Volcker Does Not Get It

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.

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  1. attempter

    I agree that this is all a matter of political will.

    (That is, for the moment. Of course the whole zombie is not sustainable either in terms of its own weight or in terms of the energy inputs necessary to sustain it. So either the right political policy can bring it down as gently as possible, or it’ll have to catastrophically collapse on its own. I guess we all know which is more likely.)

    And I agree that “resolution authority” is a scam which would never be implemented as planned in the heat of the crisis. In the crisis, panic and disaster capitalism will always supersede any alleged “plan”.

    The whole problem discussed in this post follows from the fetish of globalization itself, which is something America did not need and does not need, has only been harmful to it and will only be harmful to it.

    Sure, if people are brainwashed into the neoliberal ideology, then it follows they need multinational corporate activity and the capital markets which have risen up to facilitate it.

    And then, as Paul Sweezy, Paul Baran, Harry Magdoff and others have demonstrated, this financialization superstructure is the only outlet available for capital otherwise doomed to stagnate (that is, within the globalized capitalist framework).

    But if you jettison those malignant ideological assumptions, then alot of these seemingly intractable problems become solvable.

    Globalization has only done harm to America. It’s done nothing but destroy jobs, concentrate wealth into a hideous tumor, brainwash everyone into renouncing citizenship in favor of “consumerism”, pave the road toward totalitarianism, and in general erode the quality of life.

    We should get the monkey off our backs. And at that point there’d really be no need for any sort of casino finance.

    We’d be free. Which was supposed to be what the American Revolution was all about. Oh, how far we’ve fallen….

    (Is all of this politically not “pragmatic”? Thinking you can have financialization but “regulate” it is far more of a fantasy proposition.)

  2. alex black

    Honestly, do you think that Obama gives a rat’s ass about what Paul Volcker thinks? Volcker was a convenient symbol Obama could exploit in his campaign to try to offset his image as being “too inexperienced”. That’s the only reason Volcker has been allowed to be a background prop all this time, and the Massachusetts election was enough of a bombshell that Obama recognizes the need to re-organize his staging – so suddenly Mr. Volcker is pulled up to the front for the new dog-and-pony show. He was a great man in 1982 as he broke the back of inflation, but who really knows how sharp and agile and current he is now?

    But he makes for a damn good stage prop, and that is our President’s current priority. Nothing less and sadly, nothing more.

  3. Richard Kline

    To me, this was Volcker’s third of a loaf concessionary proposal; that’s what I thought when I read it earlier. More than most Volcker understands that government finance is political. I suspect that he sees it’s politically impossible (supposedly) to pass sufficient substantive reforms to actually bring the mega banks under control—not least because the present administration simply will not fight for such reforms. So it looks to me like he’s falling back to a ‘resolution authority and restraints on speculative plays’ pland to push in the hopes of getting that much passed. If he did so, that would be significantly more than the faux ‘reforms’ on the table now and proposals for same slipped to Bo Prez by Summers and Emanuel. Such sticks, more accurately twigs in present conditions, would give the Fed and the like the semblance of a prod to use against the oligarchs. It’s all far, far to little to in any way constrain the zombie overlords, though, and therefore bootless.

    I think, reading it, that Volcker understands more of the problem—CDS, regulatory capture, unrestrained speculation—than he tackles in the op-ed, and refrains from tackling them because he doesn’t see a winning political path to the confrontation. But where I agree that he seems to be living in the past is the general tenor of his remarks which imply that the Fed and other govrernment regulators are relevant and would be empowered given such ‘new powers.’ That was then. In his day, Paul Volcker could call up a a man like Blankfein and put the fear of Mammon’s right hand into him. Now, it’s the other way around (see Pass-throughs, AIG). When the regulators aren’t completely in the pocked of the alpha banks they quiver in terror of them. More powers won’t matter jack when the ‘leaders’ are mice amongst curs. From that perspective, Paul’s proposals, and to the extent to which they represent them his goals, seem, well _quaint_ and well-intentioned. And like something from another world, where the rich had some stake in civil society and were constrained by the government of that society to some extent. A world gone by from which Paul is the last man standing tall . . . . (‘Cept for the joe at the KC Fed who seems to have a mind of his own he’s willing to use.)

    I don’t know where we’re going, but from where I sit we’re in a war with the rich for the control of our common society. And the rich have been winning for a generation. If there’s hope it’s that a large part of the middle of the curve in the country’s populace seems to have finally woken up to that fact. But most of ’em are still hoping that somebody else will get their hands dirty winning this fight. Hoping that Volcker will win this fight for us is vain hope: he needs a movement behind him, and nothing such is in view.

    1. Anonymous Jones

      Let me second that approval. This has not been the first time, and hopefully will not be the last, that I was scrolling down to make a comment and then found that Richard had already said what I wanted to (yet far more effectively than I could have).

      I think the one other thing to consider here is that the political path is made all the more difficult by the sheer complexity of the topic. As Richard says, Volcker probably does “understand more of problem,” but the issue is ‘can he make others understand it or is it too complex?’ Perhaps he’s just dumbing it down because he thinks he must.

      As everyone here knows, I’m an arrogant asshole and a nihilistic pedant who is in over his head, yet *still* I’m going to further fan the flames by betting pounds to pennies that half the people at this *site* don’t even understand all that Yves so well elucidates in the above comment, quite amazingly and convincingly deconstructing Volcker’s op-ed. What do you think that means about the population overall, given how highly I think of most of the visitors of this forum? The public is not smart enough for complex solutions. We need to find simple solutions that sell. They might not be perfect solutions, but they’re probably better than no solutions (ah, Voltaire! Don’t let the perfect be the enemy of the good!).

      My instinct is obviously for being imperfect in this area in particular by over-regulating rather than under-regulating, and I think Yves has made a clear case that Volcker is not doing that. I believe we should fight this, but with simple, direct solutions.

      1. attempter

        Simple solutions that sell?

        But isn’t that a little, well, simplistic?

        After all, you objected, not on political but on philosophical grounds, to calling basic, decent health care a human right.

        1. i on the ball patriot

          The lowest common denominator here is that a very small group of global wealthy ruling elite are screwing everyone else. In the process they are setting those screwed one against the other by exploiting all sorts of differences and amplifying those differences.

          The simplification required is to stay on that single concept.

          The rich are screwing you and they are creating divisiveness in you. That’s it!

          Don’t worry about explaining the cause, explain who is responsible for the effects. People know the effects well.

          Simple sloganeering — • The rich have bought the now scam ‘rule of law’ and made it so complex that the little guy no longer has any justice or fairness.

          • The rich have done the same with finance. They have made it so complex that you get screwed every time you turn around!

          • Fuck the rich!
          • And fuck their phony ass FICO scores!

          Offer a simplistic solution — • Fairism. Fashioned out of a rewrite of our present ORIGINAL constitution and that will purge all of the scam complex modifying law that now favors the rich. • Fairism – where everybody has a real democratic voice in government and where reasonable limits will be set for maximum wages and total assets one person can own.

          • No corporate person hood!

          • No fed!

          • No fat ass fucking billionaires buying insurance companies and then driving the public crazy with repetitive little talking lizards on TV!

          • Utility banking with zero interest loans directly to the people from the Fairist government!

          • Fuck all of those fat ass parasitic bankers that borrow your tax dollars at zero interest and then make you pay more than double for a home and keep half themselves, or, charge 29% on credit cards, or, put you in debt slavery for an education.

          Keep it simple • Boycott for Fairism!

          Concepts are only wedges it is persistence that drives them home. Develop an aggregate citizen voice on the internet that will match and drown out the far too powerful rich man’s media!

          Now go to work! Copy paste and spread the fire!
          • Class War • Down with the fucking rich!

          Deception is the strongest political force on the planet.

          1. Toby

            i on the ball patriot i kinda second you


            can you have money WITHOUT rich-poor divides, or education gaps, or health gaps?

            i don’t know but stumbled across Arthur Shaw’s Global Resource Bank idea yesterday (it is an old idea from the early 1970s). it chimes in with my thinking that we need a money tied to value that actually exists, that is; the health of the ecosystem and the health of society as measured by crime rates and literacy etc. for Fairism to have bite and legs you need the right money to inspire the necessary cooperative and sustainable behaviours. Shaw labelled his economics Copionics, the economics of abundance. it has a certain ring.

            check it out:


            the money we have now necessarily gives rise to an entrenched rich and poor, since is it based upon the presumption of insoluble scarcity. money should be the starting point of our analysis.

          2. i on the ball patriot

            Toby, thanks …

            You will always have a wealth divide, but it should not be a rich poor divide, rather it should be a less and more divide where all are assured an equitable base share.

            We are after all, all cannibals and evolution would not sit still for any true equilibrium. The key is to find the most harmonious relationship of earnings spread, and assets owned spread, that allow us all relative comfort as individuals and at the same time moves us all forward sufficiently as a group to satisfy the driving force of evolution. Those ratios are way out of wack now and so it is a matter of democratically redefining those extremes and changing the incentivizing motivational process to reward those new extremes with; base security, opportunity, creativity, integrity, honest regulation, etc. as incentives, rather than the; greed, fear mongering, divisiveness, elite attitudes, etc., that we have now.

            Shaw presents some good ideas but very off-putting with the complexity and ‘shareholder’ language. Sounds far too corporate. Keep it simple.
            Keep money to a simple utility function.

            I think, as an ideal, and basis for discussion, you might want to play around with dividing the world’s arable land by population, and then, determining the amount of land, arable and not, to set aside for the commons, and then dividing up the remainder of that arable land for individual ownership with an eye to what is fair — hence Fairism.

            Similarly, discuss and set earnings ratios on a minimum and maximum earnings basis; 5:1, 10:1, 15:1?

            The key here is get the discussion going — outside the dominant order — under the banner of Fairism. It is difficult to co-opt the term without discussing fairness but you can be sure that it will be demonized by the likes of those silly ass sell outs, Brooks and Krugman.

            … and remember;

            Keep it simple • Boycott for Fairism!

            Concepts are only wedges it is persistence that drives them home. Develop an aggregate citizen voice on the internet that will match and drown out the far too powerful rich man’s media!

            Now go to work! Copy paste and spread the fire!
            • Class War • Down with the fucking rich!

  4. Sechel

    Securitization market is here to stay. Banks lending directly to customers has its own set of problems(duration and liquidity). I applaud Paul Volcker for his latest initiative. Paul Volcker is right that we still need exchange trading, centralized clearing and better margin requirements for swaps.

    Unanswered and a very troubling question is how the market and regulators will enforce better underwriting standards. Risk based pricing of mortgages is just a buzz word for stats quo. I do not see anything on the horizin that will curtail or forbid (no ratio/stated income mortgages), nothing to limit or prohibit drive by or statistical appraisals. And nothing to limit obscene ltv ratios. As long as the gov’t can be expected to finance this lending, what’s to stop it?

  5. charles

    La route sera longue

    Dear Yves,

    Your arguments are very valid, but I do not think in the
    current state of things,one can expect global reform with
    a hatchet,however necessary, following almost twenty years of deregulation.
    It has been said that Paul Volcker has been working on his
    plan for more than year,I like to quote his statement in the NYT following the President’s announcement:
    The heart of my argument,” Mr. Volcker said, “is who we are going to save and who we are not going to save. And I don’t want to save what is not at the heart of commercial banking.”
    In some ways, and the proposed regulation reforms in Europe are hitting the same kind of ‘brickwall’,they have
    to contend with an outgrown ‘Russian doll’, to which one sould add in the case of the American banking system,the
    legislative obstacles, the weight of the lobbies, and different bodies of regulators ( Fed, SEC, FDIC,BIS-BRI ) plus an international political will to have the IMF ‘oversee’ the G20’s reform proposals…And the arguments
    of Richard Kline’s comment only highlight another set of hurdles.
    You are very lucid in stating that unfortunately it could will take another systemic failing to see the light.Can we bear the cost ?
    I always remember that ‘bailouts’ have cost the U.S 25&
    of its GDP and 85% in the UK, and keep in mind Simon Johnson’s argument that the six largest American banks’s assets amount to 60 % of GDP, while many econbloggers express doubts about their current solvency. “Shadow banking” imho should be tackled at a later stage.

  6. The Ror

    Sadly another financial crisis will only result in more power going to the corpolitical elite in US (and UK) society.

    The effects are so subtle that few people are ever really going to understand what’s happening unless they are involved.

    I suspect T. Jefferson is turning so much a small blackhole is being created in Monticello.

  7. But What Do I Know?

    What I really like about this blog, Yves, is that you never take the easy way out (even if it makes for some depressing reading at times). It would be all too pleasant to say “Volcker knows what to do–let’s put him in charge” or “bring back Glass-Steagall, that will take care of it” (and in fact, you hear those sentiments a lot these days among the voices of reform) without admitting that the world has moved on since Volcker was in office or that the man himself is 83 and prone to living in the past.

    The system is now so big and complex that it would require the enthusiastic assent of the big banks themselves to shrink and repair it. If the leaders of these institutions are unwilling to fix themselves I don’t see how any reform can work. Only a disaster could convince them to act in concert against their own short term interests, and apparently this last crisis was not enough.

    I am much less hopeful than you that this can be solved in the real world, but for God’s sake don’t give up. Keep writing and someday someone in power may slap their foreheads and say “Damnit, Yves Smith is right!!! Why don’t we listen to her?”

  8. DoctoRx

    “More intrusive” regulation needed indeed.

    But in the country of “The Quiet Coup”, regulators can be as intrusive as idealists such as Yves and many/most of us commenters want to empower them to be, and they will intrusively continue the giveaways to their buddies in Big Finance.

    Until and unless Big Finance truly has its head handed to them (a la FDR’s first couple of years), the economy will continue to skate on thin ice. The smart money knows this and expresses such a strong preference for instant access to funds that 1 month T bills trade around zero yield. And it is not John Q Public who is out buying these on ETrade. This only happens when the smart money believes that any day, another major risk can pop up.

    FYI I’m agnostic as to whether Volcker is simply too out of date. As Chair of the G30, he is superbly placed to know EVERYTHING.

  9. dwight baker

    Yes He gets it he is paid to get it VERY VERY WELL, and for that fact his fate might be sealed for the eternal HELL.

  10. RueTheDay

    I’m on the fence with this one.

    IMO, all of this hand wringing over the distinction between customer trading and proprietary trading is largely a distraction. If you brought back Glass-Steagall, then “banks” wouldn’t really engage in any trading at all. They’d simply accept deposits and make loans (and perhaps buy Treasuries). The problem goes away.

    There are complications however. Anything that accepts deposits or deposit-like instruments MUST be declared to be a bank and regulated as such, even if they don’t call themselves one. Money market funds definitely fall into this category. Treating money market funds as banks would have other implications – the commercial paper market would dwindle away and borrowers would be forced to turn to traditional bank loans and LOCs. This isn’t necessarily a bad thing.

    Yves alludes to capital market involvement in credit provision, largely through securitization, it is presumed. Valid point. However, I’m not sold on the idea that the growth of securitization is a good thing. In fact, I’m not sure securitization on a large scale is even POSSIBLE in the absence of various types of credit insurance – GSE guarantees with implicit government backing, CDS, monolines, etc., and I don’t think credit insurance should be allowed since it sets up the sort of massive underpricing of risk we saw with the last crisis.

  11. Patitio

    I have a friend who went to school with Volker. Every time I talk to this bent over, tiny, tiny, old lady – who is still sharp in many ways – it is a reminder of how old Volker is. Could it be that age is catching up with his ability to reason things out.

  12. Bernard

    Hello Yves,

    Why don’t they ban CDS and CDOs altogether? The financial system was just fine before they came about in the past 10 years. The only reason they don’t is to preserve the fat bid/ask spreads and underwriting fees that Wall Street collects on them.

    As for your key argument as to why we can’t break up the Wall Street players:

    “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.).”

    Yes, that may be true, but this still doesn’t mean we can’t break them up into pieces and still have a “market based credit” system. There will be COSTS involved indeed, but that is the price that MUST BE PAID in order to have a safe financial system and a “free market” without public guarantees that backstop Wall Street risk-taking for the sake of huge private profits. You have not yet demonstrated that the “market based credit” system CANNOT FUNCTION with a wider range of smaller market makers. If that is the case, please explain.



    1. fresno dan

      I have a tendency to agree with your point. I forget the economic term, but there are numerous examples (e.g., strip mining) where detrimental effects are off loaded onto the public. In a cost benefit analysis, it seems to me that the costs are catching up to, and surpassing the benefits. I don’t see the benefit of ever expanding credit if credit is used to inflate bubbles and make loans to recipients that can’t pay them back.

      The question is, how much of the GDP of the last two decades was simply debt expansion. From what I’ve read, most of it. But a funny thing about debt – it gets paid sooner or later.

  13. lambert strether


    Did you mean “Tall Paul”, Yves? Or “Tall Paulie?” I’m guessing the latter.


    My understanding is that reasoning powers do not fail when the mind is kept well exercised, as no doubt Volcker has been. (This is why they keep the teebee on in nursing homes, for example; so the brain dulls and the old folks die faster).

  14. max

    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. I believe this problem is solvable, but it requires even more intrusive measures than Volcker contemplates.

    I took Volcker as starting out with carving out the normal domestic deposit system and push it off to the side and isolate it. The next step would be to carve the rest of the system into chunks. If he stops there, that isn’t near enough. On the other hand, trying to regulate leverage is doomed to failure as well – what’s leverage and how much do you actually have? The very point of ‘financial innovation’ is to pool all the money together as much as possible. Stability requires isolating and firewalling different areas off from one another, and then regulating them. Since that’s completely against the notion of pooling everything together to maximize profits (and market manipulation power) then they aren’t going to want to do that. And…

    It would be better if I were wrong, but we may need yet another crisis to produce the needed political will.

    … they have all the money, and so we won’t. I watched the banking system ‘reregulation’ antic in a Democratic Congress back in the ’80’s after the S&L crisis, so I am not surprised they’re behaving that way again.

    What it will take is probably a situation wherein the feds are simply unable to prevent a total destructive meltdown as it occurs for there to be any action. That said, I don’t think we have long to wait for the big bang; if we do have to wait a long time, well, we’ll get another sort of crisis. Of a much less pleasant sort.

    In any event, the current crisis isn’t really over from my point of view. We’re just in the boring stretch innings. (Surely Hoover’s 2 and 1/2 years of repeated exhortations that we were about to turn a corner (accompanied by complaints that he was doing too much) should provide a lesson. If not, surely the situation of the Japanese would provide a lesson. If not, surely the ’87 crash and the S&L bust followed by the fixes that eventually made things worse would provide a lesson. If not, surely the collapse of the stock market bubble plus Enron which was followed by the yeast-style blooming of the credit bubble would provide a lesson. Policymakers could decide to do something about the doom loop, but they won’t. So the rest of us have merely to be patient.)

    [‘So many lemmings, so little time.’]

  15. i on the ball patriot

    Volcker hasn’t switched gears at all, he has always been a puppet tool of the ruling elite.

    His currently assigned role (and you may argue whether or not he plays this role wittingly or unwittingly) is one of offering hope to the marks for a return from the new pernicious greed to the good old vanilla greed. Like Obama, he offers hope, and the, ‘I want to believe’ marks, are always looking for and latching on to any thread of hope.

    The real problem here is the shifting overlay, not only on finance but on all sectors of society, of the new pernicious neocon control politics that have been incrementally — and are now more rapidly — replacing the old vanilla greed politics.

    This is a “full spectrum dominance” political maneuver. The neocons have captured the attention of the global wealthy ruling elite. They are responsible for this forty year plus, fear inducing, highly divisive, coarsening of the global culture that we now exist in.

    Yes, aggressive regulation with sufficient resources would be just the answer — forty years ago. It has always been aggressive regulation that has been responsible for curtailing our cannibalistic human nature and allowing our evolution to move forward most harmoniously. But this is not forty years ago!

    We now are thrust into a very dire new world cycle where control trumps profit in the mind of the elite psychopaths that have deceptively gained control. This is not of course the first cycle of this sort in human history, there have been many local such cycles and a few of a truly global nature. What exacerbates this particular cycle, and makes it unique, and has made it such a sweet and easy deal for the neocons to pitch to the wealthy ruling elite, is the added pressure of the current global population and deterioration and depletion of resources.

    This is the mother of all battles. Its rich against poor for sure but it is also deception vs perception in the individual. Know what you are fighting for.

    Election boycotts are in order.

    Deception is the strongest political force on the planet.

    1. Potomac Oracle


      Controlling a society in the 20th & 21st centuries has involved just one variable….the quantity of credit made available by whomever controls credit. We can boycott ballot boxes and enact draconian regulations, rigorously apply anti-trust, even eliminate all of the truly speculative instruments which threaten financial stability.

      However, the public sector’s access to credit once in the hands of the private banker relegates that public entity to a subservient role. Rothschild said, “Give me the power to issue and manage a nation’s currency and I care not what laws it makes.” We are rapidly approaching the point where “too big to fail” will assume that role.

      Yves, said….”It is not acceptable in a Democracy to give the Treasury the near-unlimited check-writing authority to deal with systemic failures of highly concentrated firms.”

      On the contrary, the Treasury should have served as the creditor of last resort before Paulson turned to the Fed. But since he was in charge far be it for him to tell G-S and A.I.G. that all Treasury would cover is their capital base, everything else would have to be left to market forces or bankruptcy proceedings.

      The larger point is that Treasury can monetize much of the nations public resources to create a capital base without borrowing and a credit pool much larger than the Fed’s capital base would generate. And, under fractional reserve principles, Treasury issued credit could also be at zero or near zero rates to sustain financial markets not necessarily financial firms.

      Under current conditions of massive unemployment, the Treasury can issue debt-free funds for trillion dollar stimuls programs, universal health care, etc. The Fed would not venture here under zero rates.

    2. Toby

      “It has always been aggressive regulation that has been responsible for curtailing our cannibalistic human nature and allowing our evolution to move forward most harmoniously.”

      If humans are cannibalistic by nature, how did we create language and culture? Why, even?

      There is a very stubborn belief, even among highly perceptive and intelligent people, that human nature is hard wired and “bad.” Typically we point to history and say the evidence is there, writ large in wars and endless battling over scarce resources. But history is far more complex than merely tracking wars of conquest. Wars themselves are only possible among social animals (there could never be wars between opposing tribes of felines — Thunder Cats aside) and require things like courage and self-sacrifice. Yes the psychopaths at the top of the chain of command are psychopaths, but the gullible marks at the bottom make war possible in the end. Perhaps ignorance, cameraderie and morality are more responsible for war than cannibalistic urges…

      Please see http://www.ted.com for a talk by Steven Pinker on the myth of violence, also take a look at Peter Kropotkin’s Mutual Aid for a very erudite study of the force of cooperation in nature, and how beneficial cooperation is to species survival. Note also that Australian aborigines enjoyed an 80,000 year susttainable relationship with their environment. Very impressive. They are homo sapiens sapiens too.

      There is more to us noble beasts than war, ambition and greed, and eating each other’s flesh. You, i on the ball patriot, are proof of that.

      1. i on the ball patriot

        Toby, good questions;

        “If humans are cannibalistic by nature, how did we create language and culture? Why, even?”

        Language, which is a human externalization, was created as a tool of dominance to cannibalize other organisms. Language is a tool for deception, as are all other externalizations of all organisms. Humans are dominant because they excel at externalizing their cerebral and motor functions due primarily to greater brain size and function (there is some interesting discussion centered around whether this greater brain size is by evolutionary chance or human intentional will). Culture is simply the result of the implementation of those deceptive externalizations.

        As for ignorance and gullibility of the masses; ultimately the battle is in the individual and the struggle is one of deception vs perception in the individual. Ignorance is a product of the deceptions of the psychopaths who have created the new coarse culture through their ‘Noble Lies’ — read propaganda! It is the result of their deceptively cannibalizing the domestic population. It is not for lack of intelligence that people behave as they do.

        Toby said: “There is more to us noble beasts than war, ambition and greed, and eating each other’s flesh. You, i on the ball patriot, are proof of that.”

        First; this is ‘cannibalizing’, verb transitive here, not eating another’s flesh. It is the killing or partially arresting of the growth of another’s spirit here that we are talking about.

        Toby I’m a cannibal. We all are. My motives may appear altruistic (that is a word, an externalization and a deception) but in reality I seek to alter the alliances (and point out the deceptions in the current alliances) of cannibalizing, so as to make it more harmonious, less fearful and therefore better for me as an individual. That it might help others in the group is an incidental by product of my effort to hopefully get them to see how they are being screwed and at the same time being pitted against me in a purposefully divisive intentional conflict.

        In the end, and this takes great courage to realize I believe, because it means dropping a lot of culturally imposed brainwashing and being very perceptive and honest with oneself, all of our actions — every single one — go towards getting our needs met and sustaining life and as such they are deceptive in nature. We all must cannibalize other organisms to survive. But that realization also gives one a sense of empowerment and rewards one with a more perceptive viewpoint that ultimately allows for better survival choices as one goes about in one’s sphere of influence. I choose to take down the few psychopathic cannibals at the top and better regulate the cannibalism of the masses so as to make my world more harmonious and empowering of my spirit. Accepting that reality also makes one realize the value of open and honest societal regulations.

        Deception is the strongest political force on the planet.

          1. i on the ball patriot

            No … not really …

            I’m more cool, I work out, I drink beer and chicks want me really bad … and occasionally I let one have me.

            Within one’s sphere of influence you make your own reality in life. I choose optimism and a simple do unto others credo.

  16. Thingumbobesquire

    Many years ago yours truly had the pleasure of challenging Mr Volcker to debate the merits of his handling of the economy. He did not stop but waltzed along at DFW airport. Today’s Op-Ed in the NY Slimes evinces a true characterization of his ultima ratio.
    He opines thusly: “Here in the United States as elsewhere, some of the largest and proudest financial institutions — including both investment and commercial banks — have been rescued or merged with the help of massive official funds.”
    I retort pointedly: Mr Volcker, in heaven’s name, whatever justifies these institutions’ pride in your opinion? Now as then, I doubt I’ll get a response from this august personage.

  17. Siggy

    Nice piece. Very much to the problem at hand.

    Siggy’s view of Tall Paul. He’s old but smart, he’s not going where there’s no profit to the effort.

    Yves, you are very correct in holding that what is required has very very high political costs. The cost are so high that that the doing may be impossible in the current context and conditions. Quite probably a total collapse is necessary.

    You indicate that you want for democracy. I would prefer a return of some of the republic that we once had. More than anything, what has failed us as a society is the quality of the representatives we have elected and our collective failure as a society to individually demand ethical and prudent behaviour from us all.

    Much palaver is scribbled that thieves are in the counting houses. Much drivel is presented that looks at what was. Time has a curious attribute in terms of human existance. It’s one way, you can’t go back. The only valid reason to look back is to establish where it is that we stand today and where events are taking us.

    Where we have come from is the deregulation of our institutions of intermediation. We have debased our currency so often that the global mindset is that a dollar today buys more than a dollar tomorrow will. That fact and that fact alone drives financial creation, the drive for bigger yields. Return the store of value attribute to the currency and you will go a long way toward solving the problems at hand.

    The course of deregulation in the search of yield that offsets loss in purchasing power has led us thru a minefield of delusions that assert that you can calculate away inherent risk. So long as you permit fractional reserve deposit taking you will have failures. So long as you refuse to allow individuals and institutions to fail, you invite, you foster, greed, corruption and the destruction of the moral sentiments necessary for the existence of a sustainable economy and society.

    What is needed now is the fair discussion as to how do we restore morality and ethical conduct. How do we pay for the profilgacy of the past 45 years? Would it be fair to say that the politcal climate is such that that discussion cannot reasonably be expected to occur within the near future, I think the answer is yes.

    As to kicking on Tall Paul’s dog; I’d say give the fella a break. Recognize that he’s more a stalking horse than a messiah. Recognize that he understands his role, understand that he offering up bits and pieces that might lead to something better.

    1. eric anderson

      Siggy says: “Much palaver is scribbled that thieves are in the counting houses. Much drivel is presented that looks at what was. Time has a curious attribute in terms of human existance. It’s one way, you can’t go back. The only valid reason to look back is to establish where it is that we stand today and where events are taking us.”

      Perhaps I misunderstand you? Many people who look at the crisis allege with some credibility that it was largely based on fraud. Fraud in the lending, fraud in passing off bad loans to the securitization machine, fraud in rating and selling the securitizations. (Some of it may have been due to incompetence, but we do need to ferret out the genuine, bald-faced fraud.) Where are the prosecutions? We need to “look back” and punish the thieves, the con men, who caused a large percentage of the problem. That is not living in the past. It’s simple justice. We need to see justice, not only as proper vengeance for wrongs done, but also as a deterrent to future shenanigans.

      1. Siggy

        I agree. It’s fraud that we should be looking back for. My reference to looking back is that the economic dialogue of the past does not deal very well with the commission of fraud. What I see, in my opinion, is far too much in the way of citations of now gone indispensible men. I see a belief that we can borrow our way to prosperity. All obtained by reference to some dusty economic tome whose utility has long evaporated.

        Too Big To Fail is the biggest cannard that has been foisted on the electorate in the past 75 years. We need reliable financial institutions that when they become unworthy should enjoy the priviledge of going bankrupt. I also firmly believe that our collective failure to prosecute the fraud that lies before us invites further fraud.

        I’m mad as hell about the fact that we see so little effort being expended on the prosecution of fraud as compared to the effort being expended on the search for solutions for which the hope is that we shall in their implementation avoid some pain. This crisis is far too severe to be amenable to neat solutions. This crises will only succomb to correction thru the application of draconian measures. moreover, it will not be accomplished any time soon. Think in terms of a generation.

  18. Doc at the Radar Station

    Krugman links to an interesting FT piece that’s worth a read:


    “…But Dickson believes it is rules and not individuals that account for her sector’s survival. She points to three specific restrictions: capital requirements, quality of capital and a leverage ratio. “We had a tier one capital target of 7 per cent going back to 1999,” she says, referring to the proportion of the bank’s equity considered to be of the highest grade. “We also paid attention to quality of capital, so 75 per cent of that tier one had to be in common shares [as opposed to preferred stock, which is considered a hybrid of equity and debt]. And our leverage ratio [of debt to equity], of 20 to 1, was very important, we think.”

    1. i on the ball patriot

      Doc your magnetron has lost power and I think you might have birds nesting in your wave guides — Krugman and FT, shills for the wealthy ruling elite, are a big part of the problem.

      Deception is the strongest political force on the planet.

    2. Yves Smith Post author

      So much for those regs. On the eve of the LTCM crisis, the average leverage at investment banks was very close to that at the peak of our credit bubble (BIS leverage ratio charts show this clearly). The idea that overuse of leverage is a post 2000 phenomenon is often sold, but not as true as conventional wisdom would have you believe.

    3. DownSouth

      Doc at the Radar Station,

      Thanks for the link.

      If only the US had done like Canada and kept the banking industry tightly regulated, instead of indulging in the orgy of laissez-faire insanity that we did.

      As the Canadian example shows, sensible and effective bank reguation isn’t all that difficult, it just takes a little common sense and the political will.

      1. i on the ball patriot


        “Tracking the evolution of financial institutions
        Two views of Canadian economy – the external view is flawed

        Consider these headlines about Canada, both published this week.

        First the world view of Canada, reaffirmed at Davos.

        What Toronto can teach New York and London | ft.com

        That’s where Canada comes in. It is a real-world, real-time example of a banking system in a medium-sized, advanced capitalist economy that worked. Understanding why the Canadian system survived could be a key to making the rest of the west equally robust.

        Next a Canadian view, that says Canada is a bubble waiting to burst, that is not widely shared other than by yours truly.

        Awash in a sea of Debt | Macleans Feb 8th, 2010 (partially published on Roseth)

        It seems we have learned nothing from the American debt crisis; and here in Ontario, we have forgotten the housing collapse of the early 1980’s, when house prices dropped as much as 40 % and did not recover their old values until after the turn of the century. Speculation was rife; people kept moving up, sometimes changing homes every one or two years; speculators were “flipping” homes, and ordinary people were buying forward several months and expecting their old home to appreciate before putting it up for sale. It worked for a while, but then the market turned, and some people who had committed to a new home and waiting to sell their own at higher prices had to sell much lower and ending up with a new house but a much larger mortgage. Some seniors, selling their old, large home and hoping to move into a new, smaller home, mortgage free, ended up with a smaller home with a large mortgage. Quit claims were rampant.

        Now, here we go again”

        More here …


        … and, not to Harper on it …


        “The Canadian government shied away from fundamental reform similar to SOX on the basis that SOX was not appropriate in the Canadian context. First, the disproportionate number of small and medium enterprises in Canada would be overburdened by increasing the requirements for reporting and would potentially discourage companies from listing on the stock exchange. Second, a great share of firms is cross-listed in the Canada and the US, so they most already comply with SOX. Third, there is no federal regulating authority for stock markets in Canada, which would make legislation similar to SOX impracticable. Fourth, the government argues that increasing regulation fosters a “find the loophole” mentality whereas the present principles based system is justifiable to give room to managers for judgment that is necessary for a successful business practice.
        Although Canada did adopt parts of SOX, the regulations are not effective in preventing fraud. CEOs and CFOs are required to certify that reports do not contain material misstatements. It is argued that a signature on a financial statement cannot properly help realizing on time that fraud is brewing. The Canadian government also adopted the audit committee proposal which suggests that by creating an extra watchdog to raise flags when there is some misconduct. However, since the committee must rely on the Board of Directors to react, the committee may be futile if the Board is not willing to act. The third proposal is the creation of the Canadian Public Accountability Board which conducts tests among auditing firms to assure compliance of auditing standards. The RCMP’s Integrated Market Enforcement Team (IMET) was also created at the same time, but with results that are less than impressive. Between 2002 and 2007, the US Justice Department was able to convict 1200 individuals for white-collar crimes, while the IMET only managed two in four years.”

        More here …


        Deception is the strongest political force on the planet.

  19. km4

    Volcker says “although improved regulation and capital requirements are important, structural changes are critical”.


    Simon Johnson’s said it in May 2009
    If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform.

    Yet nothing has been done….why ?

    Because the Obama admin or our corptocracy infested Congress has NO WILL to change the status quo so the US economy will continue its over-dependence on Financial capitalism ( asset bubbles, ponzi schemes ) and Americans will get more ‘extend and pretend’ and kicking of the can down the road….

  20. meli

    “A lot of financial products simply do not trade often enough for them to be suitable to exchange trading.”

    I know you said that the article would be too long if you addressed this, but I think it comes to the core of why you are losing the plot. If those products do not trade often enough for them to be suitable to exchange trading, then they shouldn’t be trading. The fact that much of the financing is done through securitization and the otc credit markets does not necessarily mean that much of the financing must be done through highly complex, illiquid instruments, that are DESIGNED to be incomprehensible for the very PURPOSE of evading regulation and scrutiny.

    The complexity of these instruments is driven not by the need of the recipients of these financings, but by the street in order to better pull the wool over everyone’s eyes. You want to finance mortgages? Then they need to be originated to a common standard, and packaged in a comprehensible, understandable way, so that regulators can do their job. You want to finance credit cards? Then you need to create a standard for credit card origination, a standard for securitizing them, so that the regulators can understand what they are regulating and do their job.

    And those are the big ones. If this means that the new player who has researched it and decided that 52 yr-olds with blue eyes are better credit risks and want to originate to that model has a great deal of difficulty finding a way to finance that, then all to the good. If they are correct, they are perfectly free to go raise equity in the markets and originate those loans to hold to maturity. If they are wrong, they will go broke, but they won’t take the rest of us down with them.

    The pharmaceutical industry (and god knows, that’s not a perfect model) has to test and retest a new drug before they thrust it on an unsuspecting public; they have to go to the federal government and get permission to thrust it on an unsuspecting public, and credit instruments should have to do the same.

    I have a great deal of hope for the Consumer Finance Protection group (whatever they end up calling it). If they can sucessfully put limits on origination, that will ferret out some of the most egregiously illiquid securitizations because the underlying collateral will cease to exist.

    And if the bankers can’t get permission to underwrite and securitize ninja loans (no income, no job) we will have gone a long way towards putting some brakes on this train.

    1. alex

      You’ve cut right to the heart of the matter. Byzantine complexity is usually just a way to hide the scam.

      And when you’re designing “safety critical” systems you need to be careful and conservative. Sometimes you have to simplify or alter the design just so that it can be evaluated to determine if it’s safe. This is a well understood principle in real engineering. Is there some tradeoff between performance and safety? Sure, but it’s generally worth it. Thankfully people who design bridges and airplanes understand this.

    2. Yves Smith Post author


      You have a hidden assumption here, that something that does not trade often is due to complexity. That isn’t so. Virtually all bonds fit in this category: regular corporate bonds, municipal bonds, many Treasury bond issues. They are not complex and they are socially desirable products.

      1. tz

        But isn’t that why there is a liquidity premium? Somehow I don’t understand being a “market maker” in something that is so unique that it only trades once ever, or in something which is so illiquid that it rarely trades.

        And isn’t a “market maker” merely an exchange of one? Perhaps we can backstop exchanges and expand them to smaller units.

        It seems as you want something illiquid (for whatever reason) to trade at the same value as something with equivalent other risks.

        Also, why not aggregate 1000 illiquid instruments into another derivative and trade that?

        Or simply trade the stock/bonds of the underlying company and have that provide capital. If they are smart then dividends ought to be high. If they are reckless, they will go to zero.

        1. Yves Smith Post author

          Bonds are substitutes for each other in a way that stocks are not. Someone who wants to buy Microsoft stock will not view the stock of AT&T as a substitute. But (to pick a simple example), bond investors want instruments that have certain attributes, say a 5 year maturity, at least AA rating, ___ interest rate. So bond of very different companies could meet those criteria. Moreover, bond salesmen can and do suggest swaps to move their firm’s inventory.

  21. DownSouth

    Yves said:

    1) 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.

    2) It would be better if I were wrong, but we may need yet another crisis to produce the needed political will.

    Well, they used the “last” crisis to achieve #1. And Tim Geither is crowing about it:

    Because our financial system is no longer on the brink of collapse, because we’re starting to repair this terrible crisis in the financial system, I feel more confident about the basic foundation of our economy than I have for three years.

    Since the last crisis proved so successful for the TBTF bankers, what great feats could they achieve with another one?

  22. dwight baker

    My Last post did not get on — as important as it was due to the subject matter— is there a problem?

  23. John

    I’ll take Volcker over Timmeh! or Summers any day. I’d love to see Volcker go into the banking system with a hatchet and start chopping things up. I’m not too concerned about the ‘global capital markets’ or whatever the hell they are called. I just want to see some fairness back in the system.

    It sounds like from the article above that Yves is concerned that Volcker’s plan would likely lead to some type of deflationary spiral? I think that’s what we need. Credit needs to be severely curtailed. People need to go back to using cash for most purchases. 20 percent down on houses should be the minimum down payment.

    I say bring in Volcker and William Black and let them start carving the financial industry up. I think we’ll find that the current system of finance isn’t nearly as important to the well-being of 90% of the population as people who are neck-deep in it every day would like to think.

      1. craazyman

        It’s also sort of weird that Paul Volcker — who does in fact have more gravitas than all the looting parasite dandies in top management at all the too-big-to-fails combined — leads his article with the notion that we’ve “lost production”.

        That is the politically correct thing to say, given our devastated manufacturing base and unemployed population — but in reality it’s hard to see what “production” has been lost that wouldn’t have only added to the pile of useless consumer crap and shoddy and vacant MacMansions that some folks mistake for symbols of success.

        It’s hard for me to figure what production has been lost. It seems we’re sitting on a pile of junk a mile high.

        1. i on the ball patriot

          Limited choices,
          That’s the disease,
          Volcker over Timmeh!
          Oh spare me please!


          Broad brush thinkers,
          Will lead the parade,
          They’re out of the boxes,
          They see the big charade,

          Like Lady Ga Ga,
          She knows what’s real,
          She’s out of the boxes,
          Working the 360 degree deal,

          Yes the little boxes,
          Are filled with deceptive shit,
          Sure they need a cleaning,
          But that won’t help a bit,

          As long as the boxes,
          Are subject to the control,
          Of the neocon elite,
          We’ll stay in the hole …

          You are not going to get meaningful positive change from within this gangster government. Your only peaceful hope is to organize; town by town, city by city, county by county , state by state — peaceful election boycotts as a ‘vote of no confidence’ in this crooked, scum bag laced,
          gangster government.

          Your resources, and opportunity for change, are dwindling as each day goes by and the consolidation of this now fully hijacked elite global government continues. The window of opportunity will soon be closed.

          Deception is the strongest political force on the planet.

          1. MarcoPolo

            Is the consolidation not already complete?  I wrote elsewhere the coup d’état required only that one pimp with a 3 pg  memo to prostrate himself before the queen of whores and the entire putanesque govt. went for it in spite of unprecedented opposition.  Unprecedented.  C’est ca.  Fait acompli. What is needed is to overcome that insolence. I don’t see how an election boycot would be in any way beneficial as TPTB have clearly demonstrated their complete indifference to any such movement from within the traditional checks & balances.  Debt revolt?  General strike?  Jingle mail?  That risks inviting worse.

            I’m with Anon. Jones upthread who questions the ability of the common man to understand.  Well, I’ve been making an effort, but I don’t understand either.      

            The republic has been Sachs’d. Next come the Vandals.       

  24. Haigh

    Is there any reason to believe systemic risk can be regulated out of the system? The weapons of today’s regulation give birth to the armament of tomorrow’s meltdown.

    Better to set the ceiling of all future bailouts to foodstamps and let the creative and destructive powers of the market fire the powers of prosperity’s evolution. Every market participant, sovereigns, corporations, and individuals should be free to dial in their risk choices.

    1. joebhed

      Only through more comprehensive reforms than Volcker is talking.
      Even beyond Yves.
      Even beyond Kotlikoff.
      All the way to Soddy, Simons, Douglas and Fisher.
      The Chicago Plan for Monetary Reform.
      And stick with it.

  25. eric anderson

    Yves, you have an elite audience here, and I am not an elite. You know all the trees in the forest. I have no training in forestry and never worked there. Some of what you write, try as I might, is thus over my head. I do think I can resolve the outlines of the forest, though. And I would like some clarification from you.

    You wrote: “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.”

    If the world has evolved so that it cannot exist without MBS, CDOs, CDS, highly complex options, maybe it is time for the world to devolve. These seem to have become instruments that the financial tricksters use to extract good money from the economy, leaving them richer and us poorer, because as Volker himself once acknowledged, he did not see that they have added any value whatsoever to the system! (The statement, by itself, calls into question your assertion that we need these instruments.)

    As Janet Tavakoli has pointed out, it is the complexity of these deals that hides a multitude of sins. Many financial instruments were based on real estate loans that were fraudulent from the very beginning — no income verification or proper vetting of borrowers. The fraud was multiplied when those loans were sold, re-packaged, and insurance purchased against their failure.

    In my view of the forest from the open plain, what we have is essentially a moral problem. William Black has said as much. The financial crisis was the manifestation of a moral crisis.

    If you accept this, then I do not see how more regulation — in the era of regulatory capture — can function in the real world. The regulators see no evil, hear no evil, speak no evil. They will find it to their advantage not to. “It is difficult to get a man to understand something when his job depends on not understanding it.” That’s an Upton Sinclair quote that seems apropos here. This is the first reason I have doubts about the utility of hyper-regulation.

    The second reason I doubt regulation is the answer is that the complexity of the system works against it. No person or group of persons is capable of getting a sufficient grasp on the flows of money and the likely motives and actions of all the world’s financial players. To regulate, one must have sufficient understanding of that which is being regulated. Even if our hypothetical future regulators of these “many market making activities” had the best of intentions and motives as clear and clean as the wind-driven snow, inevitably their own blind spots and inability to grasp the whole complex and chaotic economic picture will render their efforts moot, perhaps even disastrous, at some point.

    How do you answer these objections? Can anyone truly understand the world of finance well enough to micro-manage it? And even if it were possible, how will we find human beings morally up to the task, people who see the right thing to do and will carry it out, even when the alternative is more profitable for them personally and their friends in high places?

    Personally, I do not see any way out except devolution, destruction, brought on by depression. I hope I’m wrong. Unless you can propose some magical system of checks and balances that will keep our regulators honest, we’re doomed. At present, we have dishonest money, dishonest financial institutions, and dishonest government control of those institutions. I can’t imagine a system of regulation that can cure those fundamental ills.

    1. Anonymous Jones

      This was a fantastic comment as well. I completely agree that micro-managing is not going to work here (and rarely works anywhere, in any context).

      Of course, devolution in this area (even as you say, ‘brought on by a depression’) is going to require the most stringent of all regulations: prohibition. Devolution would not be not the antithesis of regulation in this area; it would be the apotheosis of regulation.

      1. Kevin de Bruxelles

        I really liked Eric’s comment as well. I think it leads to what I would call the Chernobyl approach to dealing with global finance. If they continue to refuse to accept market discipline then they should be declared an existential danger to our societies and we should proceed to functionally isolate and bury them in concrete.

      2. DownSouth

        As the article Doc at the Radar Station at 11:13 a.m. linked to points out, it is the Canadians who provide the example as how to effectively regulate the finance sector.

        Of course after a 30-plus year orgy of laissez-faire insanity, it may be difficult to restore order. I liken it to a teacher that lets her students get out of control. Once she loses discipline, it is difficult to restore it.

        So what US bankers need to be treated to now is what here in Mexico they call the mano duro–the iron fist.

    2. Yves Smith Post author


      I pointed this out above, that products being traded OTC (not on exchanges) is not a function of complexity, but of the size of the issue and the propensity of buyers to trade that issue. There are plenty of socially desirable products, starting with corporate bonds, municipal bonds, that are not liquid enough to be exchange traded (perversely, that was one of the selling pitches for CDS, that they allowed investors to trade corporate bonds synthetically, supposedly increasing market liquidity. But this didn’t increase liquidity in bonds, it created a proxy market of sorts which now drives pricing of real bonds, and at times has distorted pricing of corporate bonds).

      1. meli

        Yves, I’ll admit it’s been awhile, and the details matter, but I seem to remember that even some corporate and municipal bonds have traded on exchanges, but that is just a distraction.
        What we are talking about here, is securities that are standardized enough that everyone is on the same page. Ideally, standardized enough that they are interchangeable so you can short them. (Once you get to that magic point, then you start to demand a two-sided market.)

        You have to make the traders (the ones making markets for institutional clients, providing all that ‘liquidity’) accountable, and the only way to do it is to shed all the bells and whistles and get back to basics. Some of the effects of a literal ‘exchange’ can be met by,
        1. requiring that if you are recognized by the fed you have to make a market in the issue
        2. requiring that if you are going to be recognized by the fed and allowed to participate in treasury auctions, etc., then you have to price that issue monthly
        3. those prices have to be publicly available and
        4. last, but not least, you have to be willing to make a 2-sided market, offering something comparable (perhaps not requiring shorts) and willing to stand by your bid for some minimum amount.

        Those were the rules right before securitization took hold and it was securitization that let people feel like they were off the hook. We need to put them back on that hook for an OTC market to work.

        In order to meet those requirements you have to start paring down the complexity, and believe me, the howling will be heard in the depths of hell if you do.

        As to whether or not your actually on an exchange…whatever.

  26. Kevin de Bruxelles

    Given most that most governments are totally dependent on credit via global financial institutions, does the US or any government even have the power to impose their will on the financial industry if they somehow actually acquired the will to do so? In other words have the global financial institutions grown so powerful and the rest of the world so dependent on them that global finance is beyond the point where anyone can control them?

    These questions arise from an interesting post at Global Guerrillas where John Robb discusses the current crisis with global finance through the framework developed in Carrol Quigley’s The Evolution of Civilizations and what follows is an extensive quote:


    What falls out of Quigley’s models is something totally unexpected. Universal Empire has arrived for Western Civilization (stage 5), but in a form unique in history. Due to relative weakness of our political, social and religious cultural development, economics took control and vaulted to dominance. Economics alone led the drive to Universal Empire (everyone has adopted financial capitalism, from China to Russia), and it is now firmly in control, while the other elements of Western culture wither.

    Another of Quigley’s insights is a description of how cultural elements advance through the use of social organizations that improve their function. Organizations that radically improve the level of cultural development in their target area are termed instruments. They do what they are supposed/designed to do and little else. Over time, since these organizations are run by human beings, they become institutions. They take on a life of their own, protect themselves and serve their own interests more than they advance the cultural need they were designed to advance/solve. They become ineffective and ultimately damage the entire culture if they aren’t radically reformed or replaced by a new instrument.

    The shift to institutionalism is also a good predictor of our future. Financial capitalism, the owner of Western Civilization’s Universal Empire is an institution. It has taken on a life of its own at the global level and is no longer an instrument of cultural advancement for Western Civilization. It will advance its interests at the expense of everything else. From outright fraud (the Shadow Banking system) to rentier lawfare (the proliferation of intellectual property protection to usury), financial capitalism will enrich itself mightily while the world stagnates endlessly.

    Quigley suggests that there are three potential outcomes from an institution that has gone bad.

    1.You can attempt to radically reform it. The institution either accepts this reform and improves – or – the institution

    2.fights the reform attempt. The recent global crisis and it’s pitiful aftermath is a good indicator that financial capitalism will fight reform tooth and nail, and they will win.

    3.The only other option is to build something new that routes around the institution (in this case global financial capitalism). However, that’s going to be very difficult given that it is now runs a Universal Empire and the power it can bring to bear to protect its interests is nearly limitless.

  27. GeeJay

    Volcker is being wheeled out for only one thing at this point. The dollar devaluation instore for US. He did it before, 1971, and most certainly will again. Ever wonder why they bring out the best 82 year old tool in the drawer for this?

  28. Ryan


    I’m not financial expert by any means, so sometimes these articles are hard to follow. But what has always been hard for me to understand is

    1. Where do these trillions of dollars come from?
    2. What exactly are these banks trading?
    3. If it’s speculation, doesn’t someone have to lose at some point? These profits arent sustainable forever- you would have to take bigger and bigger bets, more and more risk- it’s almost as if the system is set up to fail by design

  29. Political Heretic

    Thank you for your excellent commentary and analysis. Naked Capitalism is one of my favorite sites on the entire web.

    Also, thank the people leaving comments for some really great, thoughtful additions.

  30. dlr

    Yves says “even someone as tough-minded as he is MAY NOT RECOGNIZE the magnitude of structural change needed”

    Remember rule 1. Criminals would always prefer that you believe they are stupid rather than for you to believe they are corrupt. Banks like the way things worked out. Bailouts worked great for them. All they want are superficial, meaningless changes to delude the suckers that ‘next time will be different’. And that is exactly what Volcker is dishing up.

    Next act in this round of Kabuki Theater – banks scream with pain, to reassure voters how terribly tough these new laws will be.

    Third act – Republicans and Democrats pass the meaningless reforms, and go campaign on being ‘tough on banks’.

    They are all crooks. The Republicans are crooks, the Democrats are crooks, and the top executives at all of the banks are crooks. They are all crooks.

    We won’t get meaningful reform until they are all gone.

  31. MichaelC

    I think Volcker’s proposals for limiting commercial banking activities may seem simplistic on the surface but offers more meaningful benefits than you acknowledge, especially as it relates to ‘market based credit’.

    If the SIVs/Conduits (the so called shadow banking sytem) had been forced to operate in the sunlight without the implicit TBTF benefits they enjoyed, many of the abuses and systemic ill effects we’re dealing with now would not have occurred.

    Volcker’s limitation on commercial banking activities reduce that risk.

    Perhaps its closing the barn door, but forcing the shadow banker activities to take place outside the commerial banking umbrella is a significant policy goal.

    Given that the size of that sector was 400b plus, and assuming much of that was legitimate ‘market based credit’ provision, removing the TBTF benefits shouldn’t cripple overall credit provision.

    1. Yves Smith Post author


      I happen to be reading Charles Gasparino’s The Sellout, which is his effort to explain the crisis. He focuses on increased risk-taking across Wall Street, particularly on mortgage desks. He cites ex-Salomon staffers who describe the firm as a hedge fund….as of the mid-1980s. And they do not mean the Bond Arbitrage Group, they mean what was happening on regular dealing desks across the firm.

      I’d agree with his characterization. A great deal of risk taking occurs on customer dealing desks; you even pointed out that customer v. proprietary was not the right cut. There is nothing to limit or oversee risk taking on dealing desks (VaR as used now is no check, but your idea of using VaR in a more draconian way would be a step in the right direction). And all those are now, and remain, backstopped.

      SIVs started only in 1998, and were primarily a London phenomenon. US banks ex-Citi were not heavily involved. And the efforts to rein in conduits and securitizations are a joke. As Rolfe Winkler pointed out. Wells Fargo has $2 trillion in off balance sheet assets. It is consolidation only $10 billion, or 0.5%.

      1. Robespierre

        “There is nothing to limit or oversee risk taking on dealing desks”

        Yes there is. You assume that firms are the ones needing regulation. In my opinion easiest way to regulate anything is via taxation at the individual level (not the company). This “risk taking” happens because there is an individual who will make a lot of money in commissions. So tax bonus based compensation at increasing rates (the higher the commission the higher the tax rate).

        1. Yves Smith Post author

          I was referring to Volcer’s proposals, which do not address this issue. There are a lot of things that COULD be done, including your tax idea, but no one in authority seems to be ‘fessing up to the real issue: the authorities took a big policy leap in the crisis and are now backstopping capital markets.

      2. MichaelC


        For what its worth, in my experience Charlie’s right. In the late 90s I used to track market risk (hence the var insights) and at that time the Euro banks were luring talent from the IBs. The Euro banks didn’t make very fine distinctions between customer activity and prop trading from a management perspective.

        I wanted to draw attention to the SIVs/Conduits to highlight the kinds of activities I think Volcker is targeting.

        Since I think he’s defining ‘prop trading’ more broadly than the street realizes, I also think he’s trying to limit the definition of acceptable comm banking activity so as to exclude the type of activity the SIVs were engaged in. I’m not certain that I’m right and I stand ready to be disappointed, but..

        Nevertheless, the larger point I wanted to make was that, the banks were engaged in SIV- like business, which was basically market based credit trading, and all off balance sheet, some through SIVs, most through other OBS conduits.

        Generally the banks would structure the transactions to comply with existing accounting rules in order to get the transactions off their books (hence no capital or disclosure), but in fact the banks retained a portion and the entire exposure bounced back to them when things went wrong.

        The accountants wanted to force the banks to acknowledge them. the banks wanted to maintain the fiction they were merely arrangers. Ultimately the fiction was indefensible and the banks needed to bring them on balance sheet and thus expose the reality that these structured transactions enjoyed TBTF protections.

        They are still sitting there, with more to come as the accounting rules are finalized, and capital must be raised to support them. The issue has been kicked down the road for a while, as the implementation date for the rules keeps getting put off.

        I think Volcker would prefer that they be restructured such that they truly can be moved off the comm bank books and back into private investors hands before the consolidation rules fully kick in. Going forward, I think he has no problem letting the business operate (or fail) in the sunshine outside commercial banks.

        As you point out with the Winkler reference the numbers are material at all the TBTF banks.

        The other point I wanted to emphasize is that many of these structures contain bits of all the nasty credit products that are at the core of the meltdown, another reason to get them out of the commercial banks. They were useful distribution vehicles for lots of crappy product.

        1. Yves Smith Post author

          Volcker may want to define prop trading as something broader, but he repeated the distinction in the article that seems to be the basis of policy, prop trading v. customer trading. And within HOURS of the “Volcker Rule” being announced, the Street had ascertained that the prop trading rules would affect a mere 1% of their business.

          1. MichaelC

            I did notice that. My interpretation of his intentions may be more hopeful than realistic.

            We’ll see, its early yet.

            I do enjoy the debate, though. Thanks.

  32. Greg

    Volcker’s got no better chance at stopping any of this than George Ball had at stopping Vietnam.

    When the whole of the Establishment is arrayed against you, and the President himself has already clearly made up his mind, you’ve got no chance, and you’re only being kept on as window dressing.

  33. Jesse

    Things will change. They changed to get us here, and creatded new sets of problems. The problems have created a system that is unsustainable.

    Most of the objections to Volcker seem to be overdone to me, the kind of reaction one gets from those in system itself, when a significant change or reform is proposed.

  34. radicalized

    The reason your are disappointed is that you have not hit bottom yet (intellectually concerning the new financial order). I remember you posting, “Tall Paul is my hero.” Now its, “Tall Paul doesn’t get it”. When you post, “Tall Paul is part of the problem, not the solution” then you will have gotten it.

    Yves, no criticism intended, I love what you are trying to do, but all of us have a difficult time accepting the reality that everything that the ruling class does is intended to eventually enslave us Soviet style.

    I would love to believe that the something is better than nothing approach at least is a start. But Yves was one of the first to point out that the health care bill was worse than what we now have. Implementing it will allow the insurance industry to permanently kill any attempt at a government option. Once passed the public would soon find out that the “plan you like you can keep” is now 300% more costly, and that they simply cannot afford it. The big O’s reaction: “Were not going to over that again are we? We have passed health care reform. It’s time to move on. You health care reformers are just as nuts as the birthers”

    Incrementalism is simply another strategy to defeat real reform.

    The only solution is to fight the next American Revolution.

  35. JCH

    Brought in from the wilderness?

    Not hardly. According to Summers, Geithner and Summers and Volcker began meeting last fall to hammer out the “Volcker Rule”.

    There is what happened and then there is, unfortunately, the only alternative available – the National Enquirer version of reality.

  36. Too dumb to understand complexity

    Wow. Yves’ meticulous disassembly of Volker’s Op-ed piece illustrates the complexity of our current circumstances. On the one hand it’s clear that the wild-west atmosphere that pervaded the capital markets over the past few years just can’t continue. On the other hand, if someone with the knowledge and experience of Paula Volcker doesn’t completely comprehend (or at least does a poor job of articulating it in a newspaper) how all of the disparate players, assets and tools interact in financial markets, how do you draw the public’s attention? Strength in numbers is what’s needed. Unfortunately, they’re not going to support something that they can’t possibly understand.

    So forget about structural change in the form of big-picture systemic changes. It’s way too complex. Attack the problem in the same way Yves disassembled the op-ed piece-brick by brick. You can get the public to understand a simple concept like that. I’d suggest a good place to start is with the most obvious brick that was made with bad mud – Credit Default Swaps. That’s insurance pure and simple- start to treat it as such. Like regular insurance, you can’t buy that protection without having an “insurable interest” – which in most cases means you have to actually own the underlying asset. You can’t sell CDS protection unless you meet the minimum capital requirements along with appropriate credit ratings that prove you can up if there’s a loss- just like real insurance companies. Maybe, CDS protection sellers should be regulated by the states just like regular insurance companies.

    This is a simple concept that would be easy to explain to the average person. Explain why the current insurance industry has been set up the way it is. It eliminates moral hazard and gambling from process. As an example tell the story about how the six guys from Pennsylvania, back in the 1800’s, decided to buy insurance on the sick old guy who wasn’t expected to live very long. When he continued on unexpired beyond what they thought was a reasonable amount of time, they took things into their own hand and his demise was assured. Then six were subsequently hanged.
    They’ll get this.

    Once this brick is in place then move onto the next- securitization…

    The public will understand this process much more easily than a complex big-picture analysis, evaluation and prognosis. Just my 2 cents.

    1. Yves Smith Post author

      I agree with you completely with starting with the worst abuses, explaining why they need to be tackled, and CDS is top of the list (CDOs would not have been nearly as big a problem as they became thanks to CDS). And given the poster child, AIG, it would not be hard to get the public to understand that this is a problem that needs to be addressed.

  37. David

    Yves, your recommendation is to have lots of connections in the system, but to require lots of reserves at every step. This strikes me as complex and inelegant.

    Volcker, as a good German engineer (even if he isn’t actually an engineer), is proposing something reasonably simple the more elegant, and while it wouldn’t solve all problems, it would be a start.

    And to say that Volcker’s ideas are politically infeasible is at least premature. He works for the President! Maybe he’s speaking for the President. Maybe it will get done, at least part-way, if they decide to push for it.

    1. Yves Smith Post author


      I’ve never recommended “a lot of connections in the system”; in fact, I was writing about the problems of tightly coupled systems (per Bookstaber) LONG before regulators took it up.

      And of the things you need to decouple, depositaries are just not high on the priority list, particularly in the US. There are still pretty significant restrictions on the use of deposits to fund securities-related operation (this is a much bigger problem in Europe, which never had a Glass Steagall). This will require a lot of political capital for a problem that is not one of the real biggies.

      Numero uno is credit default swaps, but the “derivatives” reform (notice how public enemy number one, CDS, was hidden in with “derivatives”, many of which like simple interest rate swaps, are pretty tame? So guess which ones will wind up being cleared centrally? Of course, the ones that aren’t the source of trouble). Second is regulating derivatives like securities. Third is eliminating rule 3a-7 (which exempts structured products from a fair number of SEC regs). Fourth is massively beefing up SEC enforcement and letting it file criminal cases on its own (right now, it can prosecute only via the DoJ).

  38. Sundog

    I’m gonna head back up and re-read the post and read this comment thread, but first I need to say:

    Yves THANK YOU for blogging!!!

  39. chicago mike

    Even if I agree that at present

    “instruments with low liquidity don’t work well on exchanges”,

    why couldn’t there be a Wall Street version of Craigslist for trading illiquid financial instruments?

  40. 2 psi

    Hussman’s cheery tonight. He seems to expect that first-quarter announcements will supply all the ruin and bankruptcy needed to restructure the sector, as SIVs get dumped back on the balance sheet. All you need to do is have the living wills drawn up in time.

  41. Paul Tioxon

    Does Volcker know how short his reforms have fallen from what is truly needed to provide the valid solution? I would have to say yes and agree with the posts that say he knows what is politically possible and proposed along those lines. The terra incognita in which we find ourselves is the the restructuring of the USA and NATO economies in involuntary response to the collapse and the restructuring of the Soviet Bloc and a simultaneous contributing factor, China taking the capitalist road. Our entire social system as a National Security State, with the concomitant economic relationships, treaties, etc was constituted with our allies and trading partners. China and its client states and the Soviet Bloc and its client states are no longer constituted along the lines of the Cold War World. We still are to a great degree. Witness, 11 nuclear air craft carriers to protect us against the next sneak attack by the Imperial Japanese Navy, the last comparable naval fleet vis a vis the US Military. We have non existent enemies that we budget for and train against and still, 9/11 happened. Needless to say, having the richest military contractors in the world does not make us safer from attack. Our financial system has moved forward, realizing the new world that has replaced the previous Free World/Communist Bloc dichotomy. Although some redneck politicians and various reactionaries like this nomenclature, Global Financial transactions and trade is the world we are in now and the US Federal Government has to take the lead in controlling what is going on with the market makers as we do with the proliferation of nuclear weapons and other WMD saber rattlers. Our National Security and Interests are at stake and at risk if we do nothing to regulate to the point of absolute control. It is a fight to the death with oligarchs, only they are not beholden to anyone, nor are they responsible for the our social order maintaining a sense of undisruptable continuity. De Facto power of the State is non negotiable. Our sovereignty would not be handed over to Panama and Noriega,even in .000001 of a %, I do not see it going over to bankers. How much can be done to regulate here with Barney Frank on point? Not as much as what can be done by outflanking the oligarchs internationally by the globalization of reform, from the nations at Davos, particularly the socially useless banks of Great Britain. In the global environment, it will be a multi dimensional chess game of reform and counter moves to get cooperation. How much are the US and say, British politicians coordinating efforts? I would hope that a financial coalition of the willing can come to the foreground to deal with this issue, it is a global money market and our domestic politics do not regulate the whole world enough to force the issue by itself.

    As far as who rules in America, you need some other help from the social sciences: http://sociology.ucsc.edu/whorulesamerica/

  42. Ingolf

    Yves, I think you’re being too hard on Volcker. Like MichaelC, his proposals in this op-ed seem a good deal more radical to me than the way you’re reading them.

    “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.”

    As far as I can tell (and it fits with earlier comments of his), he’s suggesting a form of narrow banking where depository institutions would be the only ones underwritten by government, and would in turn be extremely tightly regulated and constrained in their activities. All other financial markets activities (with one exception which I’ll return to) would be free to take risks and innovate, but all in the certain knowledge that they would not be bailed out in the event of failure.

    For those few financial institutions too large and interconnected to be simply left to fail, he’s suggesting two things. One, by virtue of their size and interconnectedness, regulators would have the right to rein in their leverage and otherwise contain risk. Secondly, should one or more of them nevertheless fail, their liquidation should be managed by the relevant authorities according to a “living will”. As he states very clearly, though, stockholders and management would not be protected at all, and creditors would be at risk. In other words, exactly the sort of principles that should have been applied in late 2008 and early 2009.

    I accept his proposals are unlikely to be enacted but that’s a separate issue. As a plan, it strikes me as profound in its structural impact.

    I also wonder if you’re not conflating the critical importance of “market-based credit” with the systemic importance of the main capital markets players involved in that market. While their role as intermediaries is obviously important, I’d have thought the failure of one or more of could be dealt with relatively easily. Bear in mind, under Volcker’s plan, these firms would not be able to accept deposits and would be operating in the explicit absence of any official support.

    1. Yves Smith Post author


      With all due respect, you are missing the point completely.

      Narrow banking defined as depositaries is not even remotely where the action or the danger is. Look at the balance sheet even of traditional US commercial banks, one that are not capital markets firms. A pretty significant % (typically 30%) is market based funding, not deposits.

      More important, the firms that posed a systemic threat were almost without exception NOT depositaries. Where were you and Michael C during the crisis? Look at the list: Bear, subsidized takeover. Lehman, collapse with systemic consequences. Merrill, subsidized takeover. AIG, massive bailout. NONE OF THESE FIRMS WERE DEPOSITARIES. These functions may have been stuffed within commercial banks as a way for the Fed to rescue them, but that is incidental to what they are. Forcing BofA to disgorge Merrill or JPM Chase to dispose of its capital markets trading operations does not alter the fact that those activities are now crucial to our economy. And that is why they are backstopped, and will continue to be backstopped in a crisis, brave talk of narrow banking to the contrary.

      Didn’t you read the post? Banks, and that meant traditional banks, account for a mere 15% of the credit that counts in the US. And they get a fair bit of non-deposit funding.

      Credit is what is essential to commerce beyond the barter stage, NOT banking. And credit is now provided substantially through capital markets.

      The living will proposals are not realistic. Did you read what Harvey Miller, the dean of the bankruptcy bar, said in Too Big to Fail? The failure of even a middling sized broker-dealer has the potential to be a systemic event. Merely waving a wand and pretending that living wills are an answer is utter bullshit. Not a single meaningful measure has been taken or is planned to reduce how entangled the big capital markets firms are. They are all funded 50% by repos. That alone binds them together. Credit default swaps also bind them together. The proposals on central clearing will leave most CDS, if not virtually all, untouched. This living wills plan is all fantasy and window dressing.

      The living will proposals are meaningless without major structural and regulatory reform. Instead, they are being used to stand in its stead. That makes them a mere fig leaf, an empty promise. If Volcker recognizes that, he is merely a cynical operator on behalf of Team Obama. But I think he really does not understand how having a deposit base is no longer essential, or even very important, to being a systemically vital player, which illustrates how badly out of date he is.

      And please, do not try arguing that depositaries could serve the function that capital markets firms do. It would be a 20 year program to turn the clock back, and would require a massive increase in aggregate bank balance sheets, meaning a tremendous increase in equity. We are having enough trouble finding sufficient equity to recapitalize the banks we have and get them up to a healthier level of equity capital. No one considers it realistic to go back to a world of primarily on balance sheet lending. It is as difficult as getting rid of nuclear weapons. There are times when it is simply impossible to go back to prior practice, and this is one of them.

      1. Skippy

        Yves said…We are having enough trouble finding sufficient equity to recapitalize the banks we have and get them up to a healthier level of equity capital…

        That is the black hole, all are afraid to pear into…eh! Short horn equity players and their proxy’s spaghettified by the CDO/CDS singularity created by fun loving profit seekers Goldman’s/AIG et al.

        No wonder, no one, inside wants to shut down the terminator algos, dark pools, Fed window, credit reform, predatory protection etc once the biomass was striped of the financial cyborgs. Revealing the true nature of the beast, soft cell investors are liquidated en-mass to feed the needs of the beast, we serve it, not the other way around.

        Me thinks its time to pay the piper before it can get any worse. All we need to do is stop discretionary spending. All must feel the pain, although some more than others…hay…as the mob will need distraction from their pain.

        Skippy…personaly I would rather get shot once, than repeatedly stabbed by these psychopath’s, better healing out comes in the end.

      2. Ingolf

        I’m not sure who you were arguing with in this response, Yves, but it didn’t seem like me. Most of your comments have little or nothing to do with what I wrote.

        The potential importance of a “narrow banking” approach isn’t because of any expectation on my part that deposits will provide the principal means of funding in the US financial system. I’m well aware of the figures. It’s because it could be the best way to quarantine the extent of government guarantees of the financial system.

        I’m also well aware (as I’m sure is MichaelC) of the progression of the crisis. The principal thrust of Volcker’s plan, and of my comments, is the pressing need to create a new structure where all financial markets players other than depository institutions operate (and fund themselves) in the explicit absence of any government guarantee. If, in the case up a few exceptionally large and interconnected firms, the government feels it must stand behind them, it should pony up only after shareholders and creditors have already taken their hit. That, as I see it, is the truly revolutionary part of his plan (and, in all likelihood, the reason why it will never be put into effect).

        I never thought Volcker was suggesting that “living wills” could work without major structural reform. Surely that need is inherent in his description of how they’d work; it’s an entirely different world to the one we inhabit at the moment.

        To me, this op-ed piece looks like just another part of his extended guerrilla campaign within the Administration to bring about real change, with teeth. The fact that he’ll probably fail is, as I said in my initial comment, an entirely separate issue. I only commented in the first place because I thought your take on Volcker was wrong.

        Perhaps, as you say, he really doesn’t “get it”. I would have thought it’s more likely he’s just doing his best to work within the many constraints that his position and the political realities impose.

      3. MichaelC

        Here’s the point I think is missed.

        Volcker is advocating a return to a Glass-Steegal type world. Re imposing Glass-Steegal is a non-starter anyway, and he’s stated that its good some parts of it were swept away.

        But he seems to view the core investment bank/commercial bank separation as a key reform.

        His opening move in this chess game is to define the tolerable risk at commercial banks, implicitly defining undesirable risks that should be managed in a non commercial banking regulatory framework.

        The post just doesn’t persuade me that Volcker doesn’t recognize the magnitude of structural change needed to limit the extent of government guarantees to the financial sector and contain officially-backstopped risk-taking.

        Any idiot understands the capital markets role as you describe it. Is Volcker an idiot?

        (And really, “where were we during the crisis?”- WTF??)

        1. Richard Smith

          Ah yes, a sudden Yves whack. Enjoy!

          Interesting comments here. Carving out the what, 15% of relatively unproblematic deposit-based banking is a pretty muted start, IMO. Though maybe it’s more than 15%, given that securitisation markets & repo markets still aren’t doing all that much, (apart from Fed programs, anyway).

          Substantially all of the problems that need solving are in the other 85% (or whatever it is just now) of banking activity. So not much of a prospectus, yet. We will see what Volcker’s next move is, I suppose.

  43. gordon

    Thanks for an interesting post.

    “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”.

    That leaves me thinking about collateral, and what should be usable as collateral. If collateral were to be limited to cash plus liquid securities (like Treasury Bills), would that put an excessive squeeze on the “market making activities” which are said to be so necessary? Is there enough cash and are there enough Treasury Bills for the purpose? If not, is there anywhere holders of illiquid securities can go to discount them, and if not should there be?

    Thinking out loud…

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