Former Fed Chair Paul Volcker (appointed by Jimmy Carter and reluctantly reappointed by Ronald Reagan) is the person most responsible for a horrible recession in the 1980s that put to bed our high rates of inflation. My first house loan in 1980 was for a whopping 16.8% at the time. I was also getting raises twice a year that usually fell somewhere between 15-20% (yes, in banking). It was a whole different world back then.
Volcker is an imposing man both intellectually and in appearance. He towers over nearly every one in a room. He also has the ear of President Obama who placed him in charge of the analysis and planning for policy to rid the country of the systemic risk that characterizes our financial system today. The Glass-Steagall Act (GSA) of 1933 set the regime for the post-depression banking system. The Gramm-Leach Bliley Act (GLBA) of 1999-2001 removed that regime. The Volcker Rule seeks to remove the excesses of the GLBA. It is not quite GSA, but its goal is to return to separation of commercial banking from investment banking and hedge fund speculation, tighter capital controls, and a less concentrated industry.
The first details of Volcker’s suggestions are being made public. The Banker Pinata picture came from The Economist which is running a series of articles on The Volcker Rule. Right now, they’re interested in the Wall Street Reaction. I also woke up to an Op-Ed in the NYT by the man himself on How to Reform Our Financial System. Dodd is already showing signs of caving to the FIRE Lobby and is considering removing some of the language and the agency that would most protect consumers. This doesn’t surprise me because I expect him to be in the FIRE lobby by a year from now and he’s undoubtedly already beefing up his post-Senate credentials. We’ve seen Obama’s leadership method which is basically to give the right wing everything they want without doing a thing. He retreats at the mention of challenge. Volcker will not retreat. However, he’s in the process but outside the system so how truly effective can he be?
Volcker’s op ed is a concise call to action to stop the excesses of regulation capture, monopoly formation, and extraordinary profits and bonuses that resulted from the removal of transparency and oversight.
A large concern is the residue of moral hazard from the extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions. The long-established “safety net” undergirding the stability of commercial banks — deposit insurance and lender of last resort facilities — has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the world’s largest insurance company. In the process, managements, creditors and to some extent stockholders of these non-banks have been protected.
The phrase “too big to fail” has entered into our everyday vocabulary. It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks.
As things stand, the consequence will be to enhance incentives to risk-taking and leverage, with the implication of an even more fragile financial system. We need to find more effective fail-safe arrangements.
There are substantial differences–and I’ve said this a million times in this forum–between the roles of commercial banks and the roles of investment banks in a modern economy. Commercial banking should be boring and operate on a very slim margin. It consists of pooling the funds of households and businesses and placing them into loans for mundane things like inventory and cars. Just because the government now insures those deposits doesn’t mean the banks should be allowed to gamble with them. If you want to play high stakes financial engineer, got to an investment bank and go to one that doesn’t have an implicit guarantee not to fail when you screw up royally which you eventually will because the role of randomness in the financial markets is huge. You’ll get more of a sure thing in Las Vegas where the population of cards and the distribution of aces, tens, and sevens is known. The Volcker rule recognizes and respects these differences. It codifies it once more in a way not unlike the GSA but not exactly the same.
The article referenced from The Economist is the one that looks at the banks’ reaction and it is as expected. I lifted the table for your reference and the article describing the political dance around the Volcker law is referenced within the quote. (I have to tell you, there is a lot I would give up before I gave up my subscription to The Economist.) You can see exactly who the vampire squid in the room is in the graph. No wonder they own the Treasury and the White House lock, stock and FIRE bought barrel.
Though widely characterised as a return to the Glass-Steagall act, the plan falls far short of the Depression-era law that separated commercial banking and investment banking (and was repealed in 1999). Banks can continue to offer investment-banking services to clients, such as underwriting securities and making markets. The plan’s aim, say officials, is narrow: to stop Wall Street from gambling in capital markets with subsidised deposits.
The timing of the proposal—two days after Mr Obama’s party suffered a thumping Senate-election loss in Massachusetts—looks nakedly political. But it was not dreamed up overnight. Last year the president’s economic lieutenants had seemed content to shackle the banks with tougher regulation and higher capital ratios, rather than limiting their activities. In recent months, though, they warmed to the ideas of Paul Volcker, a former chairman of the Federal Reserve, who was advocating more drastic action—and after whom the new rule is named (see article).
Banks have been scrambling to estimate the potential damage. Despite the lack of detail, for most the impact looks manageable. Officials admit that new limits on non-deposit funding are designed to prevent further growth rather than to force firms to shrink. Banks were already scaling back their proprietary-trading activity sharply as a result of the crisis: some say its contribution to revenue has fallen by more than half in the past three years. Prop trading now typically accounts for a mere percentage point or two of firms’ revenues (see table)—if it is defined narrowly to exclude risk-taking related to client business. Drawing a line between the two will be horribly difficult, but that will be the regulators’ problem.
This article from the Economist on Obama’s Economic Team goes more into depth about the relative coziness of Geithner and Summers to the Wall Street Bonus class and the one thing Obama can ride back to above 50%: hatred of bankers. There may be a growing disconnect here that bodes well for the Volcker Rule. While it’s unlikely we’ll see capped bonuses, it is possible for a rework of the GSA and the so called firewall in a less intense sense. Oddly enough, Biden is a friend of Volcker’s and is playing a role in pushing the spine-challenged Obama in the direction of the Volcker Rule. There are some really odd political dynamics to this game.
I know how hard it is to get folks interested in economics and finance as I’ve now chosen this as my occupation rather than sitting inside these institutions doing the strategic planning and the overall asset-liability alignment that I used to do back in the days when my house loan was nearly 17% instead of the 7% I’ve got today. I have no idea why I find it a fascinating game of detective. Perhaps it’s something I inherited from my central banker grandfather. Perhaps it’s just one of the many quirks I’ve developed over the years. I do know, however, that now is not the time for you to go all glassy-eyed over complex derivatives. What this suggests is a way to make commercial banking boring again so that almost any one could do it and still have time for that ABA game of golf on a Wednesday afternoon.
Watch what happens to the proposed Volcker Rule. It could very well be the difference between real change and chump change. Lobby your senator and congressman because you know the FIRE lobby will be doing so vigorously and with a lot more money than you and I will ever have.