Paul Volcker (USA Former Chairman of the Federal Reserve) – Q&A following his speech, “Essential Elements of Financial Reform” (Oct 2013)
Chapters
00:00:07 Volcker Rule and International Implications
Questions and Concerns About Limiting Financial Institution Size: Paul Volcker addresses questions about limiting financial institution size in the United States and abroad. He discusses a proposal to restrain the market share of a few large financial institutions, preventing them from becoming systemically important. Volcker argues that institutions with access to 10% of the U.S. market are large enough to sustain themselves and that breaking up big banks to reduce systemic importance is unrealistic.
Potential Drawbacks and Balancing Considerations: Volcker acknowledges concerns about potential downsides, such as reduced liquidity or credit availability. He cites research suggesting that excessive liquidity encourages risk-taking and that a balance must be struck to maintain necessary liquidity without fostering overconfidence. Volcker emphasizes the need to reconcile conservative rules with the fact that many large financial institutions failed during the crisis, despite not engaging in prohibited activities. He stresses the importance of distinguishing between what banks can do and what other institutions can do, as allowing non-banks to obtain banking licenses would enable commercial banks to engage in riskier activities.
Concerns About Derivatives and Clearinghouses: Volcker agrees with concerns raised about exceptions for customized derivative products that lack transparency and are not cleared through exchanges. He emphasizes the need to strengthen clearinghouses and markets to prevent breakdowns during future crises.
Preventing Risk Transfer from Non-Banks to Commercial Banks: Gene Rockberg raises concerns about non-banks borrowing from commercial banks and transferring risk back to them through lending. Volcker responds that supervisors can monitor lending practices through prime brokerage and that regulatory authorities would have more direct leverage over large non-banks. He emphasizes the importance of avoiding conflicts of interest and risks associated with allowing commercial banks to engage in proprietary trading.
International Implications of the Volcker Rule: Randy Henning inquires about the need for other countries to adopt the Volcker Rule for it to be effective given the global nature of financial institutions. Volcker acknowledges the importance of international cooperation and the need for Europe and other jurisdictions to consider adopting similar rules.
00:12:17 Global Coordination for Financial Regulation
International Coordination: Paul Volcker emphasizes the importance of international coordination, particularly with the British, to effectively implement and sustain the Volcker proposal. Volcker believes that if the UK and other European countries adopt similar regulations, it would significantly enhance the proposal’s impact. Volcker highlights the need for the President to promote international consistency in this area and others, aiming for commonality and approach at the upcoming G20 meeting in June.
Credit Rating Agencies: Michael Pomeroy raises concerns about the shrinking number of credit rating agencies and their potential collusion, as seen in the Lehman Examiner report. Pomeroy emphasizes the need to address this issue in the proposed reforms, as the small number of agencies may prioritize collective wrongdoing over individual bravery. Volcker acknowledges the problem with credit rating agencies and expresses sympathy for the idea of allowing more specialized agencies to emerge. He suggests exploring the possibility of specialized credit rating agencies that can offer a product beyond charging the issuer, promoting competition and diversity in the market.
MoCA Rule Elements: The MoCA rule has two elements: A ban on proprietary trading for commercial banks. A size limit vis-a-vis the U.S. market.
Volcker’s View: Volcker is enthusiastic about the ban on proprietary trading but thinks the size limit is reasonable, not enthusiastic. He believes eliminating financial crises for the rest of his life is a more limited but achievable objective.
Goldstein’s View: Goldstein argues the size limit is more important than the ban on proprietary trading. He suggests reducing the size of financial institutions to a level that is more manageable and proportional to the economy’s ability to pay for them. He proposes a 10-year timeframe for institutions to come down to a size limit based on GDP.
Volcker’s Response: Volcker expresses disappointment in his own lack of imagination in considering a more drastic breakup of large financial institutions. He acknowledges that preventing further concentration of financial institutions is a practical goal.
Insights from Paul Volcker on the Financial Crisis: Excess liquidity and international imbalances played a significant role in the financial crisis, facilitating excesses in lending and borrowing practices due to downward pressure on interest rates.
The Importance of Systemic Crises Management: In systemic crises, public money and public commitment are essential to stop the crisis from spiraling out of control.
Limitations of Prompt Corrective Action: Smaller banks and financial institutions can also cause difficulties, as seen in the savings and loan debacle and the IndyMac case, which cost the FDIC $8 billion in public money.
Emergency Measures in Dodd Bill: The Dodd bill includes provisions for agencies to declare emergencies and provide assistance to the market in such situations.
FDIC’s Measures During the Crisis: During the crisis, the FDIC extended guarantees to virtually all bank borrowers of less than five years maturity, a broad measure that benefited investment banks as well.
Resolution Authority: Volcker supports the creation of a Resolution Authority to deal with troubled financial institutions in an orderly manner.
00:24:26 Global Banking Regulations Impact on Economic Growth
China’s Banking System: Chinese banks are experiencing rapid growth in lending and economic expansion. The Volcker Rule may not be effective in curbing proprietary trading in China, but it could be used to limit the operations of Chinese banks in other countries if they engage in such practices. International cooperation is necessary to address the potential risks posed by Chinese banks.
Impact of Proposed Regulations on Economic Growth: Paul Volcker believes that his proposal will not have a negative impact on economic growth, as proprietary trading is not a substantial part of banking operations. He acknowledges that other proposed regulations, such as those from the Basel Committee, may have an adverse impact on economic growth. Volcker emphasizes that the growth of the United States will not be significantly affected by such regulations.
Proprietary Trading and American Idol: Volcker criticizes the involvement of banks in proprietary trading, particularly in the entertainment industry, as it deviates from traditional banking operations. He believes that such activities could have negative consequences and should be restricted.
Inflation: Moderate inflation has been discussed as a response to economic problems, but it can be harmful and may not solve underlying issues. Inflation is not just a monetary concept but has corrosive effects on people’s expectations and rewards. Having zero price inflation is desirable, and it is important to maintain price stability.
Basel Accords: Basel Accords aim to set capital requirements, liquidity requirements, and leverage restrictions for banks. Too strict regulations could affect growth and restrict the viability of commercial banking systems. Finding the right balance between regulations and growth is a delicate task. The political pressure to go easy on mortgages led to casual capital requirements against mortgages in the past, resulting in ineffective capital requirements.
Wage and Price Controls: Wage and price controls were applied when inflation reached 3.4% in 1971, during Volcker’s time in the administration.
00:34:49 Financial Sector Growth and Compensation Discussion
Volcker’s Observations on Financial Sector Growth: Rob Scott noted the significant growth of the financial sector, surpassing manufacturing in some measures, and its connection to compensation increases. Paul Volcker acknowledged the cultural entrenchment of high compensation in the financial sector, with individuals feeling entitled to multi-million dollar bonuses. Volcker expressed concern that this focus on excessive compensation distorts perspectives on economically useful functions and creates instability.
Volcker’s Lack of Proposals for Strict Compensation Regulation: Volcker admitted that he lacked specific recommendations for strict laws to limit compensation, recognizing the deep-seated cultural nature of the issue. He emphasized the difficulty in determining the “worth” of such high compensation, as it often seems justified based on willingness to pay.
Volcker’s Perspective on Goldman Sachs’ AIG Credit Default Swaps: Volcker acknowledged the complexity of the situation involving Goldman Sachs receiving 100 cents on the dollar from AIG credit default swaps. He expressed uncertainty about whether Goldman Sachs should have taken a haircut, highlighting the challenges in determining an appropriate course of action. Volcker recognized that the solution reached did not seem entirely unreasonable given the circumstances, but he remained open to the possibility of alternative approaches.
Appreciation for Volcker’s Leadership: The moderator thanked Volcker for his willingness to face criticism and for his long-standing contributions to the country. He expressed gratitude for Volcker’s leadership during the critical time in history and wished him success in gaining acceptance of the Volcker Rule.
Abstract
Financial Reforms and the Future of Banking: Analyzing the Volcker Rule and Beyond
In a comprehensive assessment of the financial reforms proposed by Paul Volcker and others, this article delves into the complexities of limiting the size of financial institutions, the potential impact of these reforms on economic growth, and the nuances of international financial stability. The article critically examines Volcker’s perspectives, contrasting them with other experts like Goldstein, and explores the implications of regulatory measures like the Volcker Rule, Basel Capital Requirements, and the management of systemic crises. The discussion extends to the global dimension, emphasizing the role of international cooperation and the challenges posed by banks in China, Japan, Korea, and beyond.
Limiting Financial Institution Size
Paul Volcker, a prominent figure in financial reform, addresses the need to limit the size of major financial institutions. Recognizing the systemic risks posed by large banks, Volcker deems an outright breakup of these entities unrealistic. Instead, he focuses on practical solutions, highlighting the importance of preventing further concentration rather than drastic breakups. In this context, Volcker addresses questions about limiting financial institution size both in the United States and abroad, discussing a proposal to restrain the market share of a few large financial institutions to prevent them from becoming systemically important. He argues that institutions with access to 10% of the U.S. market are sufficiently large to sustain themselves, and breaking up big banks to reduce systemic importance is unrealistic.
Potential Offsets and Downsides
Volcker acknowledges the concerns surrounding the elimination of certain commercial bank activities. He asserts that removing activities that pose systemic risks has no downside, advocating for a balance between risk mitigation and maintaining a diverse financial ecosystem, where non-banking institutions can continue engaging in trading and private equity. Regarding potential drawbacks, Volcker acknowledges concerns about potential downsides, such as reduced liquidity or credit availability. He cites research suggesting that excessive liquidity encourages risk-taking and that a balance must be struck to maintain necessary liquidity without fostering overconfidence.
Reconciling Conservative Rules with Failures
Despite the failure of large financial institutions not primarily engaged in the activities targeted by reforms, Volcker stresses the need to regulate proprietary trading due to its inherent risks, citing instances of significant losses caused by rogue traders.
Derivatives and Clearinghouses
Volcker agrees on the risks of non-transparent, customized derivatives. He advocates for moving more derivatives into markets and clearinghouses, coupled with a robust review of clearinghouse strength to ensure resilience against future crises. Volcker agrees with concerns raised about exceptions for customized derivative products that lack transparency and are not cleared through exchanges. He emphasizes the need to strengthen clearinghouses and markets to prevent breakdowns during future crises.
Preventing Risk Transfer from Non-Banks to Banks
Acknowledging that non-banks engaged in proprietary trading will borrow from commercial banks, Volcker emphasizes the role of supervisory and regulatory measures in monitoring such lending practices. Prime brokerage oversight is crucial to prevent banks from over-liberal lending to large traders. Gene Rockberg raises concerns about non-banks borrowing from commercial banks and transferring risk back to them through lending. Volcker responds that supervisors can monitor lending practices through prime brokerage and that regulatory authorities would have more direct leverage over large non-banks. He emphasizes the importance of avoiding conflicts of interest and risks associated with allowing commercial banks to engage in proprietary trading.
International Dimension of the Volcker Rule
Volcker recognizes the global impact of his rule, stressing the importance of international consensus, especially with major financial markets like the UK and Europe, to strengthen the reforms. The upcoming G20 meeting presents a crucial opportunity for achieving this consensus. Volcker emphasizes the importance of international coordination, particularly with the British, to effectively implement and sustain the Volcker proposal. He believes that if the UK and other European countries adopt similar regulations, it would significantly enhance the proposal’s impact. Volcker highlights the need for the President to promote international consistency in this area and others, aiming for commonality and approach at the upcoming G20 meeting in June.
Japanese, Chinese, and Korean Banks
Highlighting the current practices of banks in Japan, China, and Korea, Volcker warns of the potential for these banks to adopt risky practices in the future, underlining the need for preemptive measures.
Transparency and Credit Rating Agencies
The issue of credit rating agency consolidation is addressed, with Volcker supporting the emergence of specialized agencies to foster competition and enhance transparency in credit ratings. Michael Pomeroy raises concerns about the shrinking number of credit rating agencies and their potential collusion, as seen in the Lehman Examiner report. Pomeroy emphasizes the need to address this issue in the proposed reforms, as the small number of agencies may prioritize collective wrongdoing over individual bravery. Volcker acknowledges the problem with credit rating agencies and expresses sympathy for the idea of allowing more specialized agencies to emerge. He suggests exploring the possibility of specialized credit rating agencies that can offer a product beyond charging the issuer, promoting competition and diversity in the market.
MoCA Rule and Perspectives of Goldstein
The MoCA Rule, advocating a ban on proprietary trading for commercial banks, finds support in Volcker’s views. However, Goldstein emphasizes the significance of size limits, proposing a reduction in financial institution balance sheets relative to GDP. The MoCA rule has two elements: a ban on proprietary trading for commercial banks and a size limit vis-a-vis the U.S. market. Volcker is enthusiastic about the ban on proprietary trading but thinks the size limit is reasonable, not enthusiastic. He believes eliminating financial crises for the rest of his life is a more limited but achievable objective. Goldstein argues that the size limit is more important than the ban on proprietary trading. He suggests reducing the size of financial institutions to a level that is more manageable and proportional to the economy’s ability to pay for them. He proposes a 10-year timeframe for institutions to come down to a size limit based on GDP. Volcker expresses disappointment in his own lack of imagination in considering a more drastic breakup of large financial institutions. He acknowledges that preventing further concentration of financial institutions is a practical goal.
Regulation and Crisis Prevention
Volcker expresses skepticism about preventing smaller bank mergers leading to large institutions and underscores the need for public intervention during systemic crises.
International Imbalances and Excess Liquidity
The role of international imbalances and excess liquidity in facilitating the financial crisis is a critical point, with Volcker highlighting its contribution to the crisis’s severity.
Resolution Authority and Emergency Measures
The creation of a Resolution Authority to resolve failing institutions without taxpayer bailouts is supported by Volcker. He also points to the Dodd bill provisions allowing emergency assistance to the market.
Impact of Proposed Reforms on Economic Growth
Volcker confidently asserts that the proposed reforms, particularly the Volcker Rule, will not negatively affect economic growth, as they target specific banking activities not central to banks’ operations.
Basel Capital Requirements
The balance between financial stability and economic growth is scrutinized in the context of stricter capital, liquidity, and leverage restrictions. Political pressures and the risk of inadequate standards are highlighted.
Moderate Inflation and Wage and Price Controls
Volcker strongly opposes the idea of moderate inflation as a solution, emphasizing the importance of price stability. He reflects on historical measures like wage and price controls, advocating against such approaches in the current context.
Executive Compensation and Financial Sector Growth
The cultural shift towards high compensation in the financial industry is acknowledged, with Volcker recognizing the trend’s impact on the sector’s growth and dynamics.
Goldman Sachs, AIG Credit Default Swaps, and Gratitude
The debate over Goldman Sachs’ handling of AIG credit default swaps is explored, with Volcker expressing uncertainty about the appropriate response. The article concludes with recognition of Volcker’s leadership and contributions, underscoring his pivotal role in shaping contemporary financial reforms.
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