Sunday, January 31, 2010

Paul Volcker Op-Ed: How to Reform Our Financial System

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A very easy to read op-ed piece by Paul Volcker which just about any competent American should be able to understand.  Now, if only they would...

Let us hope this thing is not full of mack truck sized loopholes, and consider this "too big to fail" is only 1 part of a larger mosaic of issues the financial sector has to deal with.  But it's among the most critical.

Via NY Times, some highlights below - full piece here
  • PRESIDENT OBAMA 10 days ago set out one important element in the needed structural reform of the financial system. No one can reasonably contest the need for such reform, in the United States and in other countries as well. We have after all a system that broke down in the most serious crisis in 75 years. The cost has been enormous in terms of unemployment and lost production. The repercussions have been international.
  • 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.  (incredibly key point that we raised a long time ago - this point is often lost in the discussion.  We effectively have a small cadre of "Fannie Mae" like institutions in our banking system who all the world knows will be bailed out, and hence have massive advantages in funding costs, and ability to take risk.  We know how that ended up with the GSEs)
  • 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.
  • In approaching that challenge, we need to recognize that the basic operations of commercial banks are integral to a well-functioning private financial system.  Combining those essential functions unavoidably entails risk, sometimes substantial risk. That is why Adam Smith more than 200 years ago advocated keeping banks small. Then an individual failure would not be so destructive for the economy.  That approach does not really seem feasible in today’s world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.
  • The further proposal set out by the president recently to limit the proprietary activities of banks approaches the problem from a complementary direction. The point of departure is that adding further layers of risk to the inherent risks of essential commercial bank functions doesn’t make sense, not when those risks arise from more speculative activities far better suited for other areas of the financial markets.
  • The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. (it is truly amazing the power of the oligarchs - we are resisting common sense change so that 4-5 companies can take advantage of the US taxpayer, and play in their own sandbox)  Only 25 or 30 may be significant internationally.
  • Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution. The further point is that the three activities at issue — which in themselves are legitimate and useful parts of our capital markets — are in no way dependent on commercial banks’ ownership.
  • To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new “resolution authority.” Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization.  (this is exactly what should have happened in 2008 - the American depositors should of been the only thing backstopped, not the ENTITIES.  The corporate shell that houses said deposits is irrelevant. A temporary takeover, and then over the course of 12-18-24 months - only due tot he complicated nature of these monster institutions - sell off the assets to stronger players.  This happens every Friday night in America with smaller banks, when the weak are handed over to the strong.  Reward those who did well, instead those who did poorly.  That's how "capitalism" used to work, rather than our current "corporate socialism".   But such a thought would harken to the Swedish plan and *be still the heart* it would mean temproary nationalization - ahhh, no larger slur in Ameircan culture than to be called "European")
  • To help facilitate that process, the concept of a “living will” has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts.  To put it simply, in no sense would these capital market institutions be deemed “too big to fail.” What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail.
  • I am well aware that there are interested parties that long to return to “business as usual,” even while retaining the comfort of remaining within the confines of the official safety net. (i.e. the only socialism the US practices, is socialism for the corporate - it's ok when they benefit, otherwise don't use that word or you might have some French blood in you) They will argue that they themselves and intelligent regulators and supervisors, armed with recent experience, can maintain the needed surveillance, foresee the dangers and manage the risks.  In contrast, I tell you that is no substitute for structural change, the point the president himself has set out so strongly.
  • I’ve been there — as regulator, as central banker, as commercial bank official and director — for almost 60 years. I have observed how memories dim. Individuals change. Institutional and political pressures to “lay off” tough regulation will remain — most notably in the fair weather that inevitably precedes the storm.  The implication is clear. We need to face up to needed structural changes, and place them into law. To do less will simply mean ultimate failure — failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future.
I don't know how anyone can argue with this - in almost any other industry bad decisions simply would lead to bankruptcy.  Since the banks hold a special "utility" value, they know they play by a different set of rules, and have flaunted it. 
 
Be thankful, unlike the Larry Summers and Tim Geithners of the world, there is one person looking out for someone other than their future employers.  He is akin to the one covert agent we have in our "representative" government that actually works for the people...which is why Wall Street has thrown a massive hissy fit from the moment the "Volcker Rules" were presented by Obama.  As we noted last week, the oligarchs were blind sided by this one; they are used to having their hands held each step of the way - and apparently given information before the rest of us...  hence there current reaction.   [Jan 27, 2010: Bloomberg - Financial Oligarchs Completely by "Volcker Rules"]  The first real proposal that potentially has teeth, and they don't like it - while wrapping themselves in the US flag and screaming "an affront to capitalism!".  Dogma.

Again, this is only 1 step of perhaps 10 that need to be taken ... and even this one is causing massive cries & whining.  Yves Smith at Naked Capitalism talks of all the things, even this one step, lacks - can you imagine the outcry by the oligarchs if we actually did a full sweep?  Let us see what even this most basic of common sense reform looks like after the banking lobbyists have helped to "educate and guide" the lawmakers on what little Paul Volcker knows. 

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