Paul Volcker has an op-ed in the New York Times that made my stomach sink. I had considerable hopes for Volcker’s involvement in financial reform; he’s one of the few regulators with the stature (literally and figuratively) who can say things to bankers, the media, and government officials that are unpalatable yet need to be addressed.
For instance, I’ve been delighted with Volcker’s frontal challenge to the financial services industry continued insistence that it needs to be unfettered so it can continue to “innovate”. This looks like yet another bit of Orwellianism; innovation in the financial services is tantamount to “creation of complex products that let us extract fees and shed our risks in ways the customer won’t understand.” One thing to keep in mind: even a otherwise sound investment is no good if it is overpriced, and loading in hidden charges will to just that. The most recent innovation that Volcker approves of is the ATM. He gave made some disapproving remarks to a gobsmacked audience in Sussex late last year:
Echoing FSA chairman Lord Turner’s comments that banks are “socially useless”, Mr Volcker told delegates who had been discussing how to rebuild the financial system to “wake up”. He said credit default swaps and collateralised debt obligations had taken the economy “right to the brink of disaster” and added that the economy had grown at “greater rates of speed” during the 1960s without such products.
When one stunned audience member suggested that Mr Volcker did not really mean bond markets and securitisations had contributed “nothing at all”, he replied: “You can innovate as much as you like, but do it within a structure that doesn’t put the whole economy at risk.”
Yves here. So how can you not be a fan? Well, as much as Volcker’s is suitably skeptical of the 21st century version of financial services, his remedies would work for the industry circa 1990, but look anachronistic for the world we live in now.
Now admittedly, I am basing my views on Volcker’s recent remarks and his New York Times op-ed. Now that Tall Paul has been brought in from the wilderness and is the new face of Team Obama banking industry “reform”, his freedom to state his own views may be more circumscribed than before.
But regardless, in all his comments before, there is a scary failure to mention some critical aspects the modern world of finance. The big reason banks are too big to fail is that they control infrastructure which has become critical to commerce. Most important, they control the credit markets. And credit is essential to any economy beyond the barter stage.
One reason it is hard to make this notion as explicit as it ought to be is that “banks” covers a very wide range of firms, ranging from ones that look like traditional commercial banks (they take deposits and make commercial and residential loans), to ones with substantial asset management businesses (State Street) to ones heavily involved in transaction clearing (Chris Whalen contends that JP Morgan is a $76 trillion derivatives clearing operation with a $1.3 billion bank attached) to global capital markets players like Goldman, UBS, and Deutsche Bank.
The part that Volcker keeps skipping over in his various statements is the thorniest problem from a policy standpoint: what to do with global capital markets firms. We have had an over twenty-year shift in practice. By most measures, the amount of lending that winds up being held by banks has fallen by more than 50%. Geithner, in a 2007 speech on financial innovation, noted that US banks were responsible for a mere 15% of non-farm, non-financial debt outstandings. The rest takes place via what Geithner calls “market based credit” or what others call the “originate and distribute” model (although Geithner also clearly includes credit default swaps in his use of “market based credit”).
Now even assuming we wanted a partial reversal (more on balance sheet lending), this is not an quick process. It is costly (as in banks on average would have to have much bigger balance sheets, hence vastly more equity than they possess now. Think of what it would take to reduce the use of plastic by 50% because we now know plastic has nasty environmental consequences. Going back to considerably more on-balance sheet lending would be a similarly large undertaking).
The consequence of this system of “market based credit” is that those markets have significant scale economies (network effects, high minimum scale required to be competitive, etc.). The result is a comparatively small number of firms have made themselves crucial. The Bank of England in its April 2007 Financial Stability report noted the importance of certain firms it called “large complex financial institutions” and deemed them to be important not simply due to their size, but also their crucial position in certain markets. Its list then was:
ABN Amro, Bank of America, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman, HSBC, JP Morgan Chase, Lehman, Merrill, Morgan Stanley, RBS, Societe Generale, and UBS
Of course, that list is somewhat shorter now, but a bigger issue remains: if you tried breaking the capital markets operations of these dominant firms up, those businesses would tend to evolve back into a concentrated format. And it is these origination and trading operations that make them too indispensable to fail.
In reading Volcker’s op-ed, he completely ignores the 800 pound gorilla in the room, that this crisis extended a safety net under these global trading operations. More important, the industry recognizes full well how it is now situated. These origination and market-making operations will not be allowed to seize up. Before, they merely played with other people’s money. Now they play with other people’s money and a guarantee. Having the officialdom say it ain’t so or pretend it is working towards a solution when it does not yet have one does not fool anyone who understands the real issues.
If you read the Volcker piece, “How to Reform Our Financial System,” you see an utter failure to acknowledge the problem posed by OTC credit markets (and before you say, “Put them on exchanges,” instruments with low liquidity don’t work well on exchanges. I can give you the longer form argument, but this post is already getting long. A lot of financial products simply do not trade often enough for them to be suitable to exchange trading).
Volcker first talks about traditional banks:
…we need to recognize that the basic operations of commercial banks are integral to a well-functioning private financial system. It is those institutions, after all, that manage and protect the basic payments systems upon which we all depend. More broadly, they provide the essential intermediating function of matching the need for safe and readily available depositories for liquid funds with the need for reliable sources of credit for businesses, individuals and governments.
Yves here. No where in the article does he acknowledge that, as a result of policy, much of this activity has shifted to trading markets. We still get a traditional bank-centric view:
Instead, governments have long provided commercial banks with the public “safety net.” The implied moral hazard has been balanced by close regulation and supervision. Improved capital requirements and leverage restrictions are now also under consideration in international forums as a key element of reform.
Volcker then proceeds to act as if we have traditional banking versus proprietary trading of various sorts. He discusses the flawed distinction in his proposal, of customer trading versus proprietary trading, not to suggest that market making has become (like it or not) an integral component of our credit system:
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. 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….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. These days there are literally thousands of independent hedge funds and equity funds of widely varying size perfectly capable of maintaining innovative competitive markets. Individually, such independent capital market institutions, typically financed privately, are heavily dependent like other businesses upon commercial bank services, including in their case prime brokerage. Commercial bank ownership only tilts a “level playing field” without clear value added.
Yves here. Notice the gap and the slippery use of “capital markets’? Volcker talks about commercial banks, then talks about “independent funds…independent capital markets institutions.” Where are the trading desks that serve these funds and other investors? He at best alludes to it (“heavily dependent upon commercial bank services….including prime brokerage”). Then we get this:
Very few of those capital market institutions, both because of their typically more limited size and more stable sources of finance, could present a credible claim to be “too big” or “too interconnected” to fail….What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption.
Yves here. Huh? What does he mean here? In context, is it not clear whether by “investment banks” he is referring to firms that engage only principal investing type activities, or referring players like Goldman and Morgan Stanley who are market-makers (as are Citi, Barclays, SocGen, etc.). And even if he does mean to include market-making (and it does appear he has switched gears) this bit does not inspire confidence:
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.
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.
Yves here. This idea is not politically viable, and it may not be operationally viable. AIG illustrates the difficulty of knowing how big these black holes will be when they open up, and further illustrates that they tend not to happen in isolation (as in a downdraft that can take out one systemically important player has probably imperiled others). It is not acceptable in a democracy to give the Treasury the near-unlimited check-writing authority to deal with systemic failures of highly-connected firms. While he mentions in passing the problems of connectedness, there is not enough focus on it here (and as we have discussed in earlier posts, the initial derivatives reform proposal did not do enough to address the real problem, credit default swaps, and its watered-down version looks certain to leave this product as hazardous as it was before).
And while Volcker does speak of the need for structural reform, which is absolutely necessary, his outline does not go anywhere near far enough to start defusing the bomb that financial services deregulation managed to create.
I believe this problem is solvable, but it requires even more intrusive measures than Volcker contemplates. The lesson of the Great Depression was that firms that benefitted from government guarantees had to be kept on a very short leash, and regulated in such a way that if they stayed within the rules and were competent, they would earn decent, but far from spectacular, profits.
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.
The unintended message of Volcker’s op ed may be that even someone as tough-minded as he is may not recognize the magnitude of structural change needed to limit the extent of government guarantees to the financial sector and contain officially-backstopped risk-taking. It would be better if I were wrong, but we may need yet another crisis to produce the needed political will.