Monday, February 1, 2010

Paul Volcker's Op-Ed

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.

9 comments:

Kid Dynamite said...

i would rewrite this sentence:

"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 follows:

"With stringent regulation to limit the amount of risk that capital market institutions can take on, these institutions will not need a safety net."

for me, that's the end goal - let capitalism work - firms have to be able to fail, but not take everyone else down with them. Simple. you can lose your money, but not everyone else's money too.

csissoko said...

FYI: You triggered a rant:
http://syntheticassets.wordpress.com/2010/02/01/missing-volckers-point/

balufeb2 said...

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JCH said...

Heard around a "those were the good old days" campfire in cannibalism-free New Guinea:

"People have to be allowed to be eaten."

It has certain amount of logic - that rule of the jungle mentality. Good stuff.

mike said...

I'm sorry, but I find your complete line of thinking contemptible on so many levels. Why is it that you see that too big to fail is ok, that every freakin' corrupt institution is good, that huge financial casinos need to be protected, that dismantling the likes of AIG is nonsense, that the thieves at Goldman are not deserving of contempt, and that people that want to change a repulsive banking sector, such as Volker, are idiots? And that's just on your first page!

I'm no tea bagger or anarchist, but keeping the system that we have where the connected get richer off the backs of the less fortunate, the less savvy, the less intelligent, or the less aware is absolutely ludicrous.

How come banks aren't lending? I guess there's no need to lend when the taxpayer gives them 0% borrowing interest and they can buy treasuries and commodities for much better return. Or they can charge 30% retro interest on credit card balances, or they can charge $39 dollars for a 1 cent checking account overage. And that's why we need to support this corrupt system? It sickens me - and many others - that the system is broken, but it will never be fixed by the crowd that created it - guys like you. I'm certainly no economist, but on a human level your posts and way of thinking are disturbing at best. Thanks, I needed that.

JCH said...

Mike, correct me if I'm wrong here, but these were commonly called investment banks before the crisis - no-nets (safety):

Goldman Sachs
Merrill Lynch
Lehman Brothers
Bear Stearns
Morgan Stanley

One went bankrupt and did an enormous amount of damage to the financial system and the overall economy. Two, with the assistance of the Federal Government, were purchased by safety-net banks. Two elected to become BHCs/FHCs - more regulation, access to the safety net.

So you believe Volcker when he suggests that all of the above could have gone bankrupt as long as the commercial banks, safety-net banks, were not participating in prop trading, operating hedge funds, etc., without doing the sort of damage that just one bankruptcy, Lehman Brothers, did to the financial system and the overall economy - worldwide?

Anonymous said...

Everything Mike said and then some.

The notion that it's too late to back out now just doesn't fly. It's like people where I work saying that's the way we've always done it. NO NO NO! We can stop doing stupid things. What exactly have these institutions added to the world of finance and banking that we absolutely cannot do without? Seems we apparently did without a lot of it for a long time. I really think that we just need fewer of these people around.....let the brains drain.....who cares?

Raman said...

[Safety Net + Strict Regulation OR No-safety Net + Light Regulation(only to prevent fraud)] Take your pick. I should not be penalized for your stupid greedy mistakes.

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