Last week. Bloomberg reported that Volcker, who many regard as the best asset on Obama’s economics team, is sorely underutilized:
Paul Volcker has grown increasingly frustrated over delays in setting up the economic advisory group President Barack Obama picked the former Federal Reserve chairman to lead…
Volcker, 81, blames Obama’s National Economic Council Director Lawrence Summers for slowing down the effort to organize the panel of outside advisers….Summers isn’t regularly inviting Volcker to White House meetings and hasn’t shown interest in collaborating on policy or sharing potential solutions to the economic crisis,
The usual denials ensued. But a story that corroborates this picture comes from the Globe and Mail, courtesy reader Marshall. Volcker is very much in favor where bank do the bulk of credit intermediation and focus on traditional lending. Effectively, he is calling for the re-imposition of Glass Steagall, the Depression-era legislation that separated commercial banking from investment banking. As we discuss below, this is a radical idea and is at odds with the program Geithner announced earlier this week:
The United States should emerge from the economic crisis with a two-part financial system that places tighter restrictions on banks, says former Federal Reserve chairman Paul Volcker.
To prevent another banking crisis from undermining the economy, the U.S. financial system must turn back the clock to a time when commercial banks were the core of the credit system, said Mr. Volcker…
The system that Mr. Volcker envisions “looks more like the Canadian system than it does like the American system,” he told a Toronto audience last night….
Yves here. An international survey recently put Canada’s banking system as the best in the world. It has five large banks and was never deregulated in a serious way. Back to the article:
Mr. Volcker, an imposing 6-foot 8-inch figure who chaired the Federal Reserve for most of the 1980s under former presidents Jimmy Carter and Ronald Reagan, said the primary characteristic of the new model must be strong commercial banks whose main purpose is to serve consumers and businesses, and provide credit
They would be protected by the government, because their failure would pose a distinct threat to the economy. As a result, they would require closer supervision and regulation than has recently existed in the United States. “Those institutions should not engage in highly risky entrepreneurial activities,” Mr. Volcker said.
In that central part of the system, $25-million or $50-million paydays would not be warranted, he added.
The second part of the financial system would involve the capital markets and include hedge funds, private equity funds, traders and other players who provide fluid markets. Those players would not be dealing directly with customers, and would not need to be highly regulated unless they became extremely large, Mr. Volcker said.
Mr. Volcker’s vision would mark the end of the so-called supermarket banking model, in which a single financial institution dabbles in a range of services from consumer accounts to investment banking.
Mr. Volcker blamed the current crisis largely on compensation practices that “had gotten totally out of hand,” and on “obscure financial engineering.”
“The system is broken,” he said. Fixing it will take “a lot of money and a lot of losses in the banking system.”
The Economic Recovery Advisory Board, modelled on Dwight D. Eisenhower’s Foreign Intelligence Advisory Board, will provide an independent opinion on financial issues as Mr. Obama drafts his plans for recovery.
While this prescription may sound commonsensical to most Americans, for the very big players, it runs counter to their strategic direction of the last 20 years. First, just as the House of Morgan was split into JP Morgan and Morgan Stanley in the Depression. so too would many firms have to be broken apart. Indeed, Volcker’s prescription could conceivably require brokers of various sorts (capital markets intermediaries and retail brokers) to be separate from asset managers. (Over the years where I have upon occasion worked with firms that have money management operations and brokerage, they are inevitably keen to treat their customers as stuffees).
Now why is this radical? Aside from the way it would require the dismantling of some empires built up over the years, it woudl also call for a big change in how banking is done in the US. Most consumers are not aware of the degree to which the “originate and distribute” model has taken hold. Most loans are not held by the bank that provided the loan to the customer. Just as mortgages are bundled and sold, so to are credit card receivables, auto loans, student loans, home equity loans, commercial real estate loans.
To give an idea of the scale of securitized activity, let us turn to Timothy Geithner in early 2007:
Credit market innovations have transformed the financial system from one in which most credit risk is in the form of loans, held to maturity on the balance sheets of banks, to a system in which most credit risk now takes an incredibly diverse array of different forms, much of it held by nonbank financial institutions that mark to market and can take on substantial leverage.
U.S. financial institutions now hold only around 15 percent of total credit outstanding by the nonfarm nonfinancial sector: that is less than half the level of two decades ago. For the largest U.S. banks, credit exposures in over-the-counter derivatives is approaching the level of more traditional forms of credit exposure.
We now know how that movie turned out.
Yet Geithner was a backer of financial innovation and securitization back then, and appears unwavering in his faith. From his speech earlier this week:
Second, alongside this new Financial Stability Trust, together with the Fed, the FDIC, and the private sector, we will establish a Public-Private Investment Fund. This program will provide government capital and government financing to help leverage private capital to help get private markets working again. This fund will be targeted to the legacy loans and assets that are now burdening many financial institutions.
By providing the financing the private markets cannot now provide, this will help start a market for the real estate related assets that are at the center of this crisis. Our objective is to use private capital and private asset managers to help provide a market mechanism for valuing the assets..
Third, working jointly with the Federal Reserve, we are prepared to commit up to a trillion dollars to support a Consumer and Business Lending Initiative. This initiative will kickstart the secondary lending markets, to bring down borrowing costs, and to help get credit flowing again.
In our financial system, 40 percent of consumer lending has historically been available because people buy loans, put them together and sell them. Because this vital source of lending has frozen up, no financial recovery plan will be successful unless it helps restart securitization markets for sound loans made to consumers and businesses – large and small.
Notice the repeated emphasis on getting stuck markets for various securitized assets moving again via government support? The problem is that even if what Geithner does works to a degree, it will come far short of restoring status quo ante, which appears to be his goal. Too many people who should not have gotten credit (or at least as much as they did) will not fare as well under a new regime (it would be terrible policy if they did). But they got this credit because the whole process had too many bad incentives, the biggest that too many people collected fees for sourcing or on-selling loans and didn’t suffer if the loans went pear-shaped. And the other thing that made this system work was the heavy use of credit guarantees, which were in retrospect discovered to have been underpriced.
Notice no mention in the speech of regulatory reform (except at a level so abstract that I don’t expect much) or how to fix the securitization process. Nope, we’re going to throw a trillion dollars at it instead.
Volcker’s idea, though appealing, is thus clearly at odds with the program the rest of Team Obama is on. And let us not kid ourselves about the difficulties in putting it in motion (and I don’t just mean political). John Dizard of the Financial Times pointed out one last June:
You can expect more contradictory public policies…
The process will be harder on the banks and dealers, and therefore on those who depend on them, thanks to the central banks’ hesitancy in forcing recapitalisations last year and earlier this year…
Instead, the central banks were, it seems, hoping that the relief rally in financial stocks that followed the Bear Stearns takeover would go on long enough, and be strong enough, for sufficient capital to be raised on favourable terms. We are now seeing that relief rally peter out.
There was also a fantasy on the part of some regulators that it was possible to return in short order to a world where credit was priced and extended by committees within banks.
This on-balance-sheet world, though, presupposed that the people, or, as they call them now, “skill sets” existed within banks. I remember the floors of company credit analysts at Chase and Citi in the 1970s and early 1980s. They aren’t there now.
So until the misfiring, jerry-built structure of securitised, market-priced, semi-automated credit is repaired by people who know what they are doing, there is no choice but to effectively guarantee the big institutions’ debt.
The second not trivial issue is a world of on-balance sheet banking is securitization is cheaper due the cost of holding bank equity and FDIC insurance (trust me, McKinsey had umpteen variants of charts showing the cost advantage of securitization to commercial banks so they could understand that investment banks were going to continue to eat their lunch). That will mean lower lending than in a securitized world, which most would see as an entirely good thing. It also means a world with banks needing to raise considerably more equity. Not only do they need to rebuild their wrecked balance sheets, but (in aggregate) banks will need to have a good deal more equity because collectively, far more loans will be held by banks.
Even if Volcker eventually prevails, recasting the world of finance could easily take a decade.