Guest blogger and former Congressional staffer Lune was kind enough to provide this post on Volcker’s testimony before the Senate Banking Committee today. Enjoy!
Paul Volcker, former Fed chief and currently the head of President Obama’s Economic Recovery Advisory Board, and the chairman of the Group of Thirty, testified to the Senate Banking Committee in today’s hearing on the U.S. financial regulatory system. As summarized by the NY Times, Volcker made the following recommendations:
Mr. Volcker called for the end of the mortgage lending giants Fannie Mae and Freddie Mac as hybrid public-private enterprises, saying instead that Washington should assist borrowers through “clearly designated government agencies.”
He also called for the registration of hedge and equity funds of any substantial size, as well as periodic reporting and disclosure from such firms.
For banks and other firms that are large enough to shake the entire financial system if they fail, he called for “particularly close regulation and supervision, meeting high and common international standards.”
There were other ideas discussed as well:
Among the ideas considered Wednesday was the creation of a super regulatory agency, perhaps within the Federal Reserve, which would be charged with coordinating responses among the diverse alphabet-soup of agencies overseeing financial companies….
House Financial Services Committee Chairman Barney Frank has said the first priority in overhauling financial regulation is to set up an entity to oversee systemic risks of the kind that wreaked havoc on Wall Street last year.
Mr. Volcker’s recommendations are largely drawn from the Group of 30’s report which lists the following core recommendations:
1. Gaps and weaknesses in the coverage of prudential regulation and supervision must be eliminated. All systemically significant financial institutions, regardless of type, must be subject to an appropriate degree of prudential oversight. (Recommendations 1 through 5.)
2. The quality and effectiveness of prudential regulation and supervision must be improved. This will require better-resourced prudential regulators and central banks operating within structures that afford much higher levels of national and international policy coordination. (Recommendations 6 through 8.)
3. Institutional policies and standards must be strengthened, with particular emphasis on standards for governance, risk management, capital, and liquidity. Regulatory policies and accounting standards must also guard against procyclical effects and be
4. consistent with maintaining prudent business practices (Recommendations 9 through 12.)
5. Financial markets and products must be made more transparent, with better-aligned risk and prudential incentives. The infrastructure supporting such markets must be made much more robust and resistant to potential failures of even large financial institutions. (Recommendations 13 through 18.)
While Volcker’s proposals are reasonable, they fail to deal substantively with one of the primary reasons for the regulatory failures we have seen so far. Those failures have not been from the lack of statutory authority invested in such agencies as the Fed and the SEC, but rather the lack of will to exercise that authority.
The Fed already has broad authority to investigate banks and supervise lending standards. And the SEC has ample jurisdiction to investigate such scandals as the ongoing Madoff affair.
Yet both have been asleep at the switch. As a previous article in this blog noted, Greenspan blocked proposals from his own Fed Governors to investigate predatory lending well before the current crisis (quoting from the WSJ):
Edward Gramlich, who was Fed governor from 1997 to 2005, said he proposed to Mr. Greenspan in or around 2000, when predatory lending was a growing concern, that the Fed use its discretionary authority to send examiners into the offices of consumer-finance lenders that were units of Fed-regulated bank holding companies.
“I would have liked the Fed to be a leader” in cracking down on predatory lending, Mr. Gramlich, now a scholar at the Urban Institute, said in an interview this past week. Knowing it would be controversial with Mr. Greenspan, whose deregulatory philosophy is well known, Mr. Gramlich broached it to him personally rather than take it to the full board.
“He was opposed to it, so I didn’t really pursue it,” says Mr. Gramlich, a Democrat who was one of seven Fed governors.
Similarly, the Madoff affair, including today’s testimony of SEC officials before Congress, shows the extent to which the SEC outright ignored whistleblowers’ information and attempts to get the agency to investigate gross abuses.
In today’s crisis mode, there is virtually no limit on the government’s ability to intervene in the financial industry. Yet we’re still getting bad proposals such as the TARP and the bad-bank models which commit trillions of public funds to Wall St. with no significant reform of the practices that got us in our current mess. This is not due to a lack of authority to create a better response.
Mr. Volcker and the Group of 30 are correct that we need to reform the regulatory structure. But the problem today isn’t so much with the structure itself as the fact that that structure is so thoroughly captured by the industry it’s supposed to regulate, that any authority vested in it becomes toothless.
In particular, the creation of a “systemic risk” regulator smacks of trying to isolate all the bad-cop duties of the regulators into one underfunded, powerless authority so that the rest of the agencies don’t have to do the unpleasant task of standing up to the banks when they get too big. That way, they can focus instead on serving as boosters for the industry that they will lucratively enter once their terms in government are over.
Who will stand up for the systemic risk regulator, and give it real power and influence? No one in Congress will ever get campaign contributions serving as the protector and benefactor of a regulatory agency whose sole purpose is to say “No”. Especially when by definition, the systemic-risk regulator will have to say “No” to enormous financial players with lots of money available to spend on extensive lobbying.
It is telling that in the case of financial firms that are so large and entrenched that they become Too Big To Fail, Volcker can only suggest “particularly close regulation and supervision, meeting high and common international standards.” Pardon me, but I thought that was what they were supposed to be subjected to right now. Why haven’t they been, and what in Volcker’s recommendations will actually succeed in doing it in the future?
While structural reforms are necessary, I assert the real answer to preventing the next crisis is to prevent any one firm from becoming Too Big To Fail in the first place. The advantages to the financial system of creating giant banks, aside from the stratospheric executive compensation that follows, appear to be nil. Indeed, most of the Too Big To Fail banks in this world are insolvent, and rapidly taking the world’s economy and governments with them. Eventually, most of them will be brought under (de facto if not necessarily de jure) public receivorship, broken up, and sold as parts.
We should use that opportunity to make sure they stay as parts, and don’t re-assemble into Citi-sized godzillas again.
Volcker took a courageous stand as Fed chief when he raised interest rates to stamp out inflation, even at the cost of real economic pain. And similarly, he has been one of the few inside-the-beltway economists who quickly realized the magnitude and dimensions of the current economic crisis. He should call up that courage once again and use his considerable reputation and influence to force the current goliaths to disassemble from their current Too Big To Fail sizes. Otherwise, all his reasonable recommendations on regulatory reform will be quickly made toothless by the financial industry and the government officials who serve it.