Volcker’s Historic Accomplishments:
Paul Volcker’s notable achievements include curbing inflation in the late 1970s, resolving the Third World Debt Crisis, and orchestrating the shift from the Bretton Woods system to flexible exchange rates.

Volcker’s Return to Public Service:
Despite retiring from the Federal Reserve in 1987, Volcker continued to serve in numerous government commissions, private sector task forces, and UN official commissions, demonstrating his unwavering commitment to public service.

Volcker’s Optimism Regarding Financial Regulatory Reform:
Volcker expressed optimism about the possibility of reaching an agreement on financial regulatory reform, given the progress made in the Senate and the need for a reasonably good bill.

Volcker’s Concerns about the Financial Sector’s Growth:
Volcker raised concerns about the disproportionate growth of the financial sector compared to the rest of the economy, particularly in terms of profits and compensation.

Volcker’s Questioning of the Financial Sector’s Contribution to Growth:
Volcker questioned whether the financial sector’s gains accurately reflected its contributions to economic growth and human welfare, suggesting a need to assess its role in fostering imbalances and unsustainable consumption patterns.

Volcker’s Reflection on the Financial Sector’s Role in Economic Imbalances:
Volcker pondered whether the financial sector’s practices contributed to underlying economic imbalances, such as the lack of savings and the unsustainable consumption patterns observed in the lead-up to the financial crisis.

Lord Turner’s Inquiry:
Lord Turner, chairman of the British Financial Services Authority, raised questions about the social usefulness of trading activity in financial markets. Turner’s inquiry suggests that the benefits of financial innovation may have been overstated.

Turner’s Lecture:
Turner delivered a lecture where he further explored the social usefulness of trading and financial engineering. The lecture is lengthy and closely reasoned, spanning 30-40 pages of typed text.

Turner’s Conclusion:
Turner concluded that the benefits of financial innovation have been hugely overstated.

Key Points:
Bias in Financial Reform: Volcker argues that the current bias towards conservatism in financial reform may overlook the implications of excessive proprietary trading by commercial banks. Commercial Banks’ Special Role: Commercial banks have unique and essential roles in the financial system, including providing credit to small and medium-sized businesses, supporting the commercial paper market, and ensuring efficient payment services. Moral Hazard and Too Big to Fail: The belief that large financial institutions will be protected from failure creates moral hazard, encourages excessive risk-taking, and potentially leads to future crises. Proposal for Resolution Authority: To address moral hazard, Volcker proposes a resolution authority that can take over failing financial institutions without government support, ensuring creditors bear the risk of losses. Separating Proprietary Trading from Commercial Banking: Volcker emphasizes the need to separate proprietary trading activities from commercial banking to avoid conflicts of interest and excessive risk-taking. Banking Reform Elements: Essential elements of banking reform include arrangements for assurance, clearance, and settlements of derivatives, with a focus on mitigating risks in these areas. Importance of Distinctions: Distinctions should be made between commercial banks and non-banking institutions regarding government support to avoid extending public support to all troubled financial institutions.

Necessity of Reform:
Paul Volcker emphasized the importance of financial reform due to the failures of traditional supervisory approaches, which focused on individual institutions rather than their interrelationships. He highlighted the rapid rise of derivatives, particularly credit default swaps, and the need for broad oversight of both financial institutions and markets.

Role of Legislation and Strict Rules:
Volcker stressed the need for legislation and strict rules in certain areas, such as resolution authority, restrictions on proprietary activity, controls on derivative trading, and the requirement for institutions to maintain a significant part of the risk in their own books. He argued that supervisory discretion alone cannot maintain the necessary level of discipline over time.

Addressing Cultural Challenges:
Volcker acknowledged the deep-seated cultural challenges in the financial industry, including the loss of professional pride and fiduciary responsibility, and the prevalence of excessive compensation practices. He expressed doubts about the effectiveness of legislation in addressing these issues and emphasized the importance of strong and respected regulatory agencies.

Reliance on Government Support:
Volcker pointed out that the financial system relied heavily on government support and that the economic system was threatened during the crisis. He urged policymakers to seize the opportunity to make necessary changes and not waste the lessons learned from the crisis.

International Consensus:
Volcker noted the progress made in achieving international consensus on financial reform and the recognition of the need for change. He expressed optimism that legislation could be passed during the year.

Potential Offsets and Downside:
In response to concerns about potential offsets or downsides, Volcker argued that there is no downside in limiting the activities of commercial banks. He cited Dale Turner’s analysis on liquidity, concluding that more liquidity is not always beneficial and can encourage risk-taking.

Proprietary Trading and the Financial Crisis:
Paul Volcker acknowledges the positive aspects of liquidity but emphasizes the need to limit its growth and the number of institutions involved in trading, hedge funds, and private equity. He highlights that proprietary trading contributed to the financial crisis, particularly outside commercial banks, but it was not the central cause. Volcker emphasizes the risks associated with proprietary trading, citing examples of rogue traders causing significant losses. He expresses his intention to distinguish between what banks can do and what other institutions can do to prevent commercial banks from engaging in risky activities.

Derivatives and Regulation:
Volcker emphasizes the need for caution in handling derivatives, particularly customized products that lack transparency and are not cleared through exchanges. He agrees that there is a strong interest in keeping derivatives out of clearinghouses to maximize profitability, and he stresses the importance of fighting against this trend. Volcker calls for reviewing the strength of clearinghouses and markets to ensure they can withstand future crises.

Proprietary Trading and Risk Mitigation:
Gene Rothberg raises the concern that if proprietary trading is restricted in commercial banks, non-banks may engage in highly leveraged proprietary trading and derivative activities, potentially transferring the risk back to commercial banks through lending. Volcker acknowledges this risk and suggests that controlling lending to non-banks could mitigate it.

Risks of Proprietary Trading:
Proprietary trading by commercial banks poses risks that need to be controlled. Banks lend to these institutions and must lend to them, especially through prime brokerage. A supervisor can review prime broker practices and ensure they don’t impair bank stability.

Regulatory Controls for Big Traders:
Some bills assume larger traders will have more direct regulatory controls. It’s harder to do this within the same organization due to conflicts of interest and gaming. The goal is to avoid inviting these risks and conflicts.

Volcker Rule Impact:
The number of banks engaging in proprietary trading is small. The concern is that this practice could expand significantly in the future. The temptation and perceived rewards are great, despite occasional crises.

International Coordination:
Effectiveness and sustainability of the Volcker Rule would be enhanced by coordination with other regulatory authorities. UK and European coordination is critical, given their large financial markets. Getting the UK and Europe on board would be a significant step forward.

Challenges in Transparency:
The system relies on transparency from accountants, lawyers, and credit rating agencies. The number of credit rating agencies has shrunk significantly. A small number of agencies may collude rather than act independently. Credit rating agencies pose a challenge that needs to be addressed.

Solutions to Financial Crises:
Volcker emphasizes that he lacks a simple solution to eliminate financial crises entirely but aims to prevent them for the remainder of his lifetime.

Credit Rating Agencies:
Volcker advocates for more specialized credit rating agencies with distinct products, beyond the dominant players like Moody’s, Standard & Poor’s, and Fitch.

Volcker Rule:
While Volcker supports the ban on proprietary trading for commercial banks in the Volcker Rule, he is less enthusiastic about the size limit provision.

Size of Financial Institutions:
Morris Goldstein argues that reducing the size of financial institutions, particularly those with assets exceeding $100 billion, is crucial to addressing the “too big to fail” problem.

Resolution, Capital, and Liquidity:
Goldstein emphasizes the importance of resolution authority, higher capital and liquidity requirements, and wind-down authority in addressing systemic risk.

Size Limits:
Goldstein believes that size limits on financial institutions are the key to resolving the “too big to fail” issue.

Practicality of Breakup:
Volcker acknowledges the challenges in drastically breaking up financial institutions, citing potential claims of unfairness and the difficulty in preventing mergers and acquisitions within size limits.

Excess Liquidity and International Imbalances:
Volcker assigns substantial weight to the role of international imbalances and global capital flows in facilitating the excesses and lending practices that led to the financial crisis.