I think it’s safe to say that Yves Smith and I don’t see eye-to-eye on much. But on Paul Volcker’s latest op-ed, we largely agree: Volcker simlpy doesn’t get it. I have the utmost respect for Volcker, but he seems to be fighting old battles. He emphasizes the importance of — and the need to extend the safety net to — depository institutions like commercial banks. He contrasts commercial banks with "capital market institutions," which he does not believe should have access to the safety net. Capital market institutions, Volcker believes, should "be free … to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail."
I’m sorry, but were we watching the same financial crisis? The clear lesson from the financial crisis is that certain capital market institutions are every bit as important to the day-to-day functioning of the modern economy as commercial banks. That’s a positive statement, not a normative one. Lehman Brothers was not a commercial bank, and yet its failure had catastrophic consequences for the global economy.
If anything, Volcker is not advocating enough government intervention. Capital market institutions need to be given access to the safety net — but just as with commercial banks, access to the safety net has to come with stringent regulation to limit the amount of risk that capital market institutions can take on. As Yves says:
The world has evolved so that many market making activities are now as essential to commerce as deposit gathering and lending. Those activities are de facto backstopped; there is simply no ready way back here (trust me, even if there were, it would take twenty years, and we’d still need an interim solution). We need to regulate those activities aggressively, including requiring much more capital to support them, and strict limits as to how much and what type of credit these firms can extend to hedge fund and other speculative investors.If you accept that certain capital market institutions have become just as important to the day-to-day functioning of the modern economy as commercial banks — and given what we witnessed in September 2008, I don’t see how that could be seriously disputed — then how can you justify extending the safety net (with stringent regulations, of course) to commercial banks, but not to those capital market institutions? Volcker essentially wants to implement a resolution authority for capital market institutions, and then send them on their way (leaving them "free to innovate, to trade, to speculate, to manage private pools of capital"). While I think a resolution authority is the most important element of financial regulatory reform, I certainly don’t think it’s sufficient. We need to extend the formula for commercial bank regulation (safety net access + stringent regulation) to capital market institutions. Volcker seems to be pretending that the lesson of the financial crisis is that we just need to clamp down harder on commercial banks. I think that’s misguided.