Goldman, Morgan Stanley Can Escape Volcker Rule

Just as we suspected, the “Volcker Rule” proposed by the Administration fails to acknowledge the new facts on the ground: that the crisis took place in the capital markets, and that some of the major participants were funded by deposits was incidental. Half of the balance sheet of major dealers comes from repos, and a seize up in the repo markets was a major (and generally unacknowledged) crisis mechanism.

The most remarkable bit of a story up at Reuters is that the key element is buried partway through, although Huffington Post (hat tip reader Tim S) zeroed in on it:

Some institutions will be able to avoid facing the Volcker rule by shedding their insured deposits, according to U.S. Deputy Treasury Secretary Neal Wolin on Monday.

Goldman Sachs Group, which funds fewer than 5 percent of its assets with deposits, could easily change its funding profile to get out from under the rule.

So the Treasury would like to get tough with banks that hold a lot of deposits, and blithely ignore the fact that it rescued (via forced mergers) Bear and Merrill, neither which held deposits, that the failure of Lehman, again, not a depositary, nearly precipitated a systemic collapse, and that the powers that be felt compelled to rescue AIG, again not a depositary. Oh, and that it allowed Goldman and Morgan Stanley to become banks and receive TARP funds because their failure was feared to create a systemic failure.

Notice that the Reuters article focuses on the idea that the plan could conceivably work, ignoring that it will preserve the worst aspect of the status quo: that guarantees have been extended to capital markets firms, and a considerable portion of them are not going to subject to more strict regulation as a result.

So if this proposal moves forward (but all indications are that it won’t), expect Bank of America to spin out Merrill post haste and for JP Morgan to engage in loud complaints about how unfairly it is being treated (Citi would like to as well but presumably knows better). And that over time will lead to the rule being gutted. The reason Glass Steagall became irrelevant (and it was well before it was formally rescinded in 1998; the only practical consequence of that act was to remove an impediment to the Citigroup-Travelers merger) was that commercial banks had pointed to how investment banks were eating their lunch and earning more money and demanded a more level playing field. They got a series of variances starting in the 1980s, with the result by the mid-1990s that commercial banks were represented in the top ten in pretty much all major investment banking products. So while the Volcker Rule could in theory lead to a return to Glass Steagall, the big problem, the need for tougher restrictions on capital markets players (NOT depositaries) remains unaddressed.

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  1. Sir Oasis of the Liver

    OK, so just as a dumb question, why is JPMorgan so quiet about this, given that they’ll be hit while GS and MS won’t?

    My guess is that nobody really expects this bill to go *anywhere* whatsoever. Just more smoke and mirrors.

    1. Yves Smith Post author

      Correct, did say that in post yesterday, but notice how Reuters played up the proposal as if it meant something. Will tweak the post, since I am relying unduly to the fact the title to the other post is up in Recent Items.

      1. jake chase

        this volker rule is no buried in Alabama mud thanks to that great patriot senator sam shellgame; no doubt he will produce an alternative ve-hickel to jump start our vibrant free enterprise system. what are the odds on not hitting a moron when tossing a paper airplane from the senate galary?

  2. danny

    I think even if the the administration devise a plan to perfectly reign in speculative activites it wont matter because the structural imbalances to perpetuate this crisis or for another to emerge are already inplace.

    The next crisis to profit from could emerge as a result of soveriegn problems, deficits, excessive credit levels, a return to declining housing markets, chinese bubbles, currency movements, etc.

    These crisis all facilitates greater global governance and in time I think the goal is to bypass things like the congress too while just having some global body of inside appointees running things on behalf of the corporate syndicate.

  3. Thomas Barton, JD

    I may be suffering from TBTF Observation overload but I thought that IF the Treasury measures Volcker pointed to it would be worthwhile to implement his rule.. I want Goldman and the others to leave their bank holding status.. If they do as Volcker proposes would they not then be subject to his little-discussed second prong : they will be euthanized not saved when they run aground again (next month or 2012). Volcker himself seems to acknowledge the limits of his proposed rule but the effect seems to be beneficial to get Goldman “out in the flats “.

    1. Yves Smith Post author


      I’ve argued elsewhere that the “living wills” proposal is meaningless absent other changes that are simply not taking place.

      These firms are deeply enmeshed through counterparty exposures, particularly repos (they all fund each other) and credit default swaps. The “derivatives” reform plan has been gutted as far as CDS are concerned. As long as they are enmeshed, no firm can be allowed to fail. One going down imperils them all. And since the markets they run are essential for commerce, that will not be allowed to happen.

      So if Goldman et al. get in trouble, they WILL be rescued. They know that. Moreover, they no doubt know it is to their advantage to complain like crazy about what little in the way of change is visited on them, to give observers the mistaken impression that Something Meaningful Has Been Done. If they can persuade everyone that they are indeed being made to suffer under the new rules, surely moral hazard has been eliminated, right? Wrong.

      1. Hugh

        The interconnectedness problem is why the only way to fix the system is for the government to go in and take over the system and sort out (as best it can) all the various offsetting exposures. It could also enforce settlements with other players such as other international players and hedge funds. I don’t think even this country has the resources to prop up this system in the form of endless Japanification. The other alternative is settlement through collapse (an unmanaged reset). I am afraid that is the direction we are headed in because I do not see our elites as capable or willing to engage in a system wide managed reset.

  4. Skippy

    A congress of the powers is deceit agreed on between diplomats…Napoleon.

    Skippy…what else needs too be

  5. Sechel

    You miss the point. Volcker is concerned about FDIC and Fed Window support of proprietary trading. Let them leave an convert to a lesser status and compete like everyone else. In the meantime, Congress can point to you your objections and block this important legislation.
    There’s truth that this doesn’t address swaps and flash trading, but why does one bill have to solve it all.

    1. Yves Smith Post author


      Flash trading is an abuse but not a systemic risk. And you are missing my point.

      These firms were NOT depositaries pre crisis and they were backstopped. Do you not think that they will be rescued again if they get in trouble? The powers that be made them banks on an emergency basis, now that the Fed figured out how to do that, it will be even easier to do it a second time (as in they crossed that Rubicon and worked out the procedural bugs).

      The reason these firms were backstoped is

      1. Credit is essential to any society beyond the barter stage.

      2. Debt markets are now at least as important in providing credit as traditional lending, by a lot of measures, even more so

      3. A handful of firms are crucial because they operate the debt markets

      4. These firms are deeply enmeshed. If one goes, the others are at risk of failure, which will take down the entire debt markets apparatus.

      1. is a fact of life. These proposals are inadequate re 2-4. As a consequence, were this rule implemented (which it appears won’t happen anyhow), and Goldman or Morgan Stanley or a spun out Merrill got in serious trouble, it would be rescued, and all rescues have involved either combining the sick firm with a depositary or having the Fed lend directly.

      Moreover, having some firms de facto backstopped but still largely free to conduct themselves as before increases the odds of a blowup. It’s called moral hazard. See the famous paper by George Akerlof and Paul Romer on looting. This is precisely that sort of situation.

  6. Rickk from Canada

    “….Escape Volker Rule”

    I wonder why?

    Tuesday, February 2, 2010 – Washington Times – excerpt

    “The work computer of one regional supervisor for the U.S. Securities and Exchange Commission showed more than 1,800 attempts to look up pornography in a 17-day span: “It was kind of distraction per se,” he later told investigators but he wasn’t alone. More than two dozen SEC employees and contractors over roughly the past two years have faced internal investigations after they were caught viewing pornography on their government computers, according to records obtained through the Freedom of Information Act and other public documents.”

  7. Paul Tioxon

    Systemic crisis in the financial system is not predicated upon FDIC deposits being jeopardized, but the ability to generate a disruption up to a total seizure of the credit markets, which we just experienced. The solution has to be more than to deal with the smallest component of a system, that is recognized by the public, their demand deposits, but also the 21st century capital aggregates outside of the FDIC banking system’s traditional purview. The scale of capital accumulation and deployment is now on a scale beyond any which Mr Volker had to contend with. It seems on a scale beyond our national sovereignty as it is now constituted and would need international cooperation, especially with London and Paris and other relevant nodes in the financial system to effectively regulate the behavior of the various banking entities. The analogy to pirates on the open seas is relevant here.

  8. dingding

    If the Volcker rule goes into effect the amount of derivatives will drop significantly since GS and MS will find fewer counterparties to trade against and their balance sheets cannot support the level of trading that the big commercial banks can.

    1. Yves Smith Post author

      I don’t see that as a given. The dealers and banks all matched their CDS positions, and that was far and away the most problematic derivative in the crisis; they’d argue that that therefore falls within customer trading, not prop trading. They’d also argue that given the illiquidity of those markets, and their perceived value (they were able to get lots of corps to act as their mouthpieces before Congress), that running a position for a few days or maybe even a few weeks until they find a counterparty should be permitted.

      Moreover, we haven’t even gotten to the issue of correlation models and other risk management tools. For instance (and this was back as of the early 1990s, mind you), derivatives positions (for bona fide derivatives, one that are priced in relationship to an actively traded underlying; CDS don’t fall into that category) would be hedged not by not by hedging the security/instrument directly, but by hedging the risks across the book. That creates model risk. How exactly is the Fed going to approach this problem? You not only have position risk, you have model risk

  9. Thomas Barton, JD

    Yves, thanks for the response to my comment and Sechel’s. They were pointed and clear and now I see no way out for this country. I thought that at worst the powerful would get their 5 years to recoup their ” paper losses ” of 2008. What can possibly be done to reverse this ? Has our Everyday Functional Economy been completely subsumed by the Repo and CDS universe ? Cheers…?

    1. Yves Smith Post author


      I think this bomb can be disarmed, and worse, it probably could have been disarmed had Obama taken action when he came into office. The banks were on the ropes, there was talk of nationalizing Citi and BofA. He had a lot of leverage then that he chose not to use. This was an abject, utter failure of will and imagination.

      I set this forth longer form in my book, but first is to seek to wind down CDS as much as possible (there are reasons you can’t simply ban the product overnight) by regulating them very intrusively, in particular restricting their use to cases where the person buying the CDS owned the underlying or had a bona fide commercial reason to get a CDS contract, ie. an insurable interest. When you’ve whittled down the market, then see if it can be killed. The product has virtually no valid uses and plenty of opportunity for abuse.

      You then regulate essential capital markets functions VERY aggressively, AND limit how those firms + depositaries lend to the speculative players. There is NO reason a hedge fund should get credit from a bank, save against very safe collateral like Treasuries or with very big haircuts, and then only in liquid markets with verifiable prices (like the 50% now in theory in place for equities)

      1. danny

        I think a solution to TBTF is to simply nationalise as soon as a bank fails or is about to fail. At this point the government should continue to honor all obligations to counterparties and wind down the bank and reprivatise in an orderly manner. I dont see how this would cause contagian to capital markets.

        In order to prevent the next crisis a key aspect is to ensure central bank transparency because all the funding for derivatives or speculative/manipulative banking practises comes directly and indirectly from the FRB. So if the CB is transparently independantly audited then excesses can be identified as they are emerging. The key source of funding for derivatives has to be recieved by the primary dealers which conduct OMO’s with the fed IMO.

      2. andrewg

        Any chance you can expand your thoughts on (i) what you think are essential capital markets functions and (ii) what VERY aggressive regulation means in practice?

      3. scraping_by

        It may not have been a lack of will or imagination. Remember that the Resolution Trust Corporation (RTC) set up to wind down the failed S&Ls in the 1980s was under the FDIC. Even at the beginning, Ms. Bair was probably not seen as a team player by the Wall Street trading houses who financed Pres. Obama. Thus, instead of a tried and proven method, a whole litter of bizarre subterfuges were put into place. The cost was almost certainly greater than declaring them insolvent and salvaging what could be.

        A good and pissed-off primer on the S&L crisis and the RTC is Martin Mayer’s book The greatest ever bank robbery: the collapse of the savings and loan industry. A superlative that was accurate, in its time.

  10. MichaelC


    Thank you for drawing our attention to the central weakness of the reform package.

    As you noted above

    These firms are deeply enmeshed through counterparty exposures, particularly repos (they all fund each other) and credit default swaps. The “derivatives” reform plan has been gutted as far as CDS are concerned. As long as they are enmeshed, no firm can be allowed to fail. One going down imperils them all. And since the markets they run are essential for commerce, that will not be allowed to happen

    So, its the other pieces of the plan that are flawed. Your disappointment that the Volcker plan doesn’t fix the flaws in the other bits wasn’t clear to me and as a result I had trouble with your argument that the Volcker plan was flawed.

    Have you considered that the since the Volcker rule doesn’t address the derivatives and non CB it refocuses attention on your point. It further draws attention to the fact that the ‘gutted’ derivatives and non bank solutions are inadequate and were negotiated in bad faith by Congressmen and the bank lobby.

    Tall Paul may be crazy like a fox. Its not a bad strategy to develop a good plan for the commercial banks to shine a light on the inadequacy of the other bits that seem to have been gutted. He knows there are brilliant people like you that are paying attention and will catch on to his strategy and support it by demanding the derivatives and super regulator proposals be enhanced.

    No wonder Dodd and freinds are so angry with his proposal. It shines too much sunlight on their corrupt efforts.

    1. Yves Smith Post author

      It would be much better if your interpretation was correct, that Volcker has deliberately crafted an incomplete plan to open up issues that are supposedly closed.

      But I have trouble seeing how this happens in practical terms. Volcker is too much of a good soldier to go into open opposition. And I can’t seem him criticizing bills that the Administration has put forward as inadequate.

      I see Volcker’s sudden move to the foreground as a rather desperate attempt by the Obama administration to rebrand itself. I’m not certain how much muscle the Administration is prepared to put behind the “Volcker rule” (one interpretation, as you noted based on Volcker’s testimony, is that he did intend it to reach to the Goldmans of the world, but Treasury is not backing him on this). And even if Dodd is upset, I don’t see how tougher legislation gets put forward.

      The reactions from the Senate point to Team Obama scrambling, um, repositioning:

      Chris Dodd, Democratic chairman of the committee, offered support for the “Volcker rule” or a “variation” of it but lambasted the administration and said the Treasury was not giving good answers to questions.

      “The idea that the administration made such a major point a week or so ago, seemed to many to be transparently political and not substantive,” he said. “And it’s adding to the problems of trying to get a bill done.”

      Richard Shelby, the senior Republican, criticised the way “this concept was air-dropped into the debate” months after the administration had put forward its regulatory reform plan.

      1. MichaelC

        I have no head for interpreting the political posturing and maneuvering, so I can’t comment on your analysis there.

        I have no idea if it was Volcker’s intention to undermine Team Obama’s earlier work on the derivatives / super regulator/ non comm bank oversight, but that does seem to be a consequence of his move, hence all the griping from Congress about him throwing sand in the works on the already agreed and gutted pieces. That sounds like a good outcome to me.

        “The big banks, the lobbyists say, have become increasingly alarmed that the legislative process may move in unexpected directions outside their control.”

        The political motivation behind the Volcker rule or the benefits/costs to Team Obama doesn’t really matter to me, even though it may matter to the politicians and bankers .

        If the effect is to create a set of reasonable restrictions for commercial banks, do those rules weaken the overall reform package?

        I don’t think you’ve argued that it does weaken the overall reform package, more that it doesn’t address the more critical issues. If it “does no harm” why oppose it?

        Since the Volcker plan would likely result in GS and MS debanking, shouldn’t we be focusing on the protections they would still enjoy thanks to the House plan and open an attack on that front and support Volcker’s effort on the commercial banking side?

        1. MichaelC

          Sorry, strike this bit from my comment. I don’t think its correct.

          I don’t think you’ve argued that it does weaken the overall reform package, more that it doesn’t address the more critical issues. If it “does no harm” why oppose it?

          1. Yves Smith Post author

            Because it uses scarce political capital ineffectively.

            It’s a different topic, but look at Obama’s stimulus plan. Most economists said at the time it was inadequate (although most also agree that the economy would be even weaker had it not been put in place). So now what is the right wing saying when the stimulus didn’t do much? “See, stimulus doesn’t work.”

            When you have a deeply entrenched industry, you must shoot at and hit the highest priority targets.

      2. Ingolf

        “But I have trouble seeing how this happens in practical terms. Volcker is too much of a good soldier to go into open opposition. And I can’t seem him criticizing bills that the Administration has put forward as inadequate.”

        I wonder about that, Yves. After reading Volcker’s interview with Charlie Rose in early January, it seemed to me he’d had it with being a “good soldier” and was going to use his reputation to try to push through something sensible. Makes sense in a way . He doesn’t have anything left to prove, and at 82, maybe his legacy is top of mind.

        Consider these quotes:

        “In interviews in the past you said that’s why we needed to change the political process; that’s why you thought that candidate Obama was the best choice for President.

        True. But has he been able to do that at this point? It doesn’t look that way. I think that’s unfortunate. I wish the Administation would pay more attention to what’s needed to improve the ordinary functioning of government. We can’t even fight a war with our own people any more. We’ve got to hire Blackwater. I think people have lost confidence in government, they’ve lost trust in government, and it shows. This isn’t a question just of this Administration. It’s been kind of a steady, downhill path.

        Yes, but this Administration came in and said it would change. That was the mantra of the campaign. So what happened?

        It shows you it’s not that easy to change.”

        As you rightly suggest, there’s every reason to doubt how far the administration might be willing to go in backing him, but I think there’s reasonable evidence that he’s willing to run a private campaign for reform rather than simply toe the line or act as a figurehead.

        In one of your earlier comments, you wrote:

        “The reason these firms were backstopped is

        1. Credit is essential to any society beyond the barter stage.

        2. Debt markets are now at least as important in providing credit as traditional lending, by a lot of measures, even more so

        3. A handful of firms are crucial because they operate the debt markets

        4. These firms are deeply enmeshed. If one goes, the others are at risk of failure, which will take down the entire debt markets apparatus.”

        All reasonable points, I think. However, Volcker’s approach aims to take account of these concerns in two principal ways.

        First, he sees underwriting as a crucial function of the new, sanitised commercial banking sector. Some portion of the operation of the debt markets would therefore be guaranteed and tightly regulated.

        Second, the capital markets firms that handled the balance would be free to do so, but under his proposed system the capital of both shareholders and creditors would explicitly be at risk. That would mean the effective capital available in the event of failure would be greatly deepened, quite possibly to the point where outright failure from the point of view of counterparties would be highly unlikely. It would also radically change the risk/reward calculations of creditors and therefore, in time, the capital markets firms they’re funding.

        It’s this latter part of Volcker’s plan which is by far the more important. The so-called “Volcker rule” about commercial banks seems as much a feint as anything else; important, yes, but principally useful as a way of cutting the rest of the financial system off from government guarantees. True market discipline, if enforced in this fashion, would make the remaining tasks of regulators a great deal easier.

        I think that’s his real dream, doomed though it probably is given the political realities.

        1. Yves Smith Post author


          I think we are not going to see eye to eye on this one. This idea that anyone will allow a dealer that is part of the crucial debts market infrastructure to go bust is just not a happening event. Volcker uses the word ‘euthanized”, the Fed talks about living wills, but with no action on connectedness (and this is a full bore operation, not a few tweaks here and there), a dealer failure is a massive liquidity draining event. And whatever external event pushes one dealer into insolvency will have the others looking wobbly, not in a position to weather a further market downdraft well.

          Or put it this way: if they do let a dealer go bust to prove a point, it will be regarded as an even worse error of judgment than the Lehman BK (big caveat: unless we see MAJOR action to reduce connectedness, but I see no sign of that).

          1. Ingolf

            It may not so much be a matter of not seeing eye to eye, Yves. If anything, we seem to be gradually removing some misunderstandings.

            I agree (and always have) that the obstacles to thoroughgoing reform are formidable. Indeed, the political system may be so broken that it’s effectively impossible. And yes, reducing connectedness (one way or another) seems essential if we’re ever to have a sensible financial system.

            My argument (and I think Volcker’s) has been more about the sort of broad structure we should be aiming for rather than focusing on the many steps necessary to get there. That may be why we’ve in part been talking past each other.

            In those terms (and setting aside for a moment the many interim steps necessary to get there), do you see it as desirable to eventually have most of the financial system operating in the explicit absence of government guarantees, and therefore for creditors as well as shareholders to be at risk in the event of a failure?

          2. Yves Smith Post author


            You use the phrase, ‘most of the financial system”. That obscures the issue. I am very clearly talking about the international debt markets infrastructure. That is going to be backstopped (or if a critical player is allowed to fail, we will have a worse than Lehman event). A seize up in the credit markets has very serious repercussions for the real economy.

            These firms do not fail slowly and gracefully, as commercial banks do. They collapse catastrophically, in very short periods of time. And when one is wounded badly enough to be insolvent, it is a near certainty that at least some of its peers will be badly wounded as well. Thus euthanizing one, if it involves ANY inconvenience to counterparties, will lead to runs on the wobbly looking ones. The ONLY reason FDIC resolution is so successful is that it has worked out mechanisms to make sure that depositors never lose access to their funds.

            Now perhaps these living wills could be made to work. But it will take substantial reduction of the interconnections among firms, AND mechanisms in place to assure that counterparties can continue to trade. How exactly can that work? In a bankruptcy, you freeze creditor claims. The idea of “euthanizing” or allowing these firms to fail is in conflict with the need of counterparties to be able to trade their positions. Until there is a solution to that conundrum (and I haven’t seen one yet), I don’t see how this living wills fantasy works.

            So we can pretend all we want to that these functions will not be backstopped. This is not an issue of an explicit guaranteee. There is a big time implicit one (and as I indicated in a later post, if for political reasons a firm is allowed to fail, it will be a worse than Lehman event. Just as with AIG and the TARP recipients, the next firm to hit the wall and those at risk would be supported).

            So the only answer I see as viable is to regulate the critical functions like utilities. This is infrastructure crucial to modern commerce, the folks who operate it have abused their privileged position. I don’t see any other solutions. While this is a very intrusive solution, the measures needed to “de-couple” the major financial firms would be at least as intrusive. It would take a more radical than the breakup of AT&T intervention.

          3. MichaelC


            I can’t find a flaw in ingolfs comment, nor do I understand the Yoda like response to my last post.

            Am I to conclude that it’s your view that since Volcker’s plan doesn’t address the critical issues that are also not adequately addressed in the other pieces (resolution authority, restraints on non comm banks and derivaties) then
            it must be killed? Is the highest priority target Team Obama’s proposal, the House Bill or what?

            Isn’t that a killing the people to save the village strategy? I don’t follow your reasoning on this issue.

            It escapes me how attacking Volcker’s proposals furthers the cause of meaningful reform, especially since the efforts to date are so dissapponting.

            I also don’t understand the political calculus, so I’m way out of my depth here and hope you can enlighten me.

  11. Lyle

    Simple way to shut down prop trading require a 50% equity backing for it, i.e. a 1 to 1 leverage ratio max. This would match what individuals can do with stock today. It would make prop trading unprofitable very rapidly, and can be done with legislation beyond that of allowing the regulators to set capital requirements for various activities. Let them engage in prop trading but make it an unprofitable business. To add to this put loans to hedge funds in a 50 50 bucket in banks as well. This will put them out of their misery rapidly as well. It may decrease liquidity of the market but will teach folks to always stay more liquid in the future.

  12. Siggy

    Very interesting post. I agree Tall Paul is a stalking horse for a non starter of reform legislation. A see, we’re doing something bit of theater.

    You hit on a very important point. They’re all non-depository institutions and they’re all interconnected. Did you also notice that they’re also ‘primary dealer’ banks?

    Consider the interdependency. Why should that be? There is so much credit money out there that there shouldn’t be the need for repos, unless, of course, your speculating.

    There is also something about this that causes me to believe that we could have let them all go down. Would it have stopped trade, yes for a few months but there would have been a recovery. I also note that the count of closed banks continues to mount, yet we have not yet reached 1,000. That said I also note that the FDIC is out of funds for resolutions.

  13. BC

    Good morning, all. Can someone please explain the “Volcker Rule” to me? I’ve done my best to look it up online, but most definitions are diluted, at best, and I don’t really understand it. Also, even though I am a graduate student, can someone explain it to me as if I were 10? Kidding… Sorta’. Thank you for your help.

  14. Jesse

    Firstly, IF they shed their insured deposits I would hope this would negate their status as banks, and access to the Treasury guarantess and the Discount Window.

    Goldman doesn’t give a hoot for deposits. They want more wholesale access to Other People’s Money. I would have thought this was obvious.

    Secondly, this argument that it would not stop any problems because of Lehman and Bear is an obvious canard, ie ‘spin.’

    One would like to assume there would be other methods of controlling the ‘hedge funds’ and ‘investment banks’ by limiting their leverage AND their involvement and counterparty exposure with banks.

    After all, IF the problems at BEar or AIG or Lehman had been isolated to themselves and their debt and shareholders, their qualified investors, and not placed a risk to the entire system through a web of counterparty risk, who would have cared?

    See, the arguments are all based on what Wall Street wants: nice complex rules managed by cooptable regulators, like that meme that Bobby Corker kept repeating about Rule 23A.

    People still do not get it. This was not some accident, some act of God, some failure in engineering. This was fraud, before and after the fact.

  15. Ingolf

    Yves, sorry to be so long in replying to your comment (6:40PM on the 3rd). I tried yesterday but the site was down and I just didn’t get back to it.

    You answered my question in your last paragraph (for which I thank you), but not quite in the fashion I’d hoped. It still feels like your (no doubt very acute) understanding of the practical difficulties precludes much consideration of structural alternatives.

    Before going on, I need to clear up one misunderstanding. I’m painfully aware, as we all are, of the “big-time implicit” guarantee. It was an explicit “absence” of guarantees that I was recommending in my last paragraph, not explicit guarantees.

    Nor was there any intention to obscure in talking about “most of the financial system”. I simply meant the system outside of commercial banking (and any other depository institutions included under the same regime of tight regulation and overt guarantees). The critical component, as you say, is of course the international debt markets infrastructure.

    I’m sure your understanding of the firms comprising this market greatly exceeds mine and my intent is not to quibble with your analysis of the current and prospective difficulties. I accept it’s an unholy mess (have done for years), and also that left to their own devices, these institutions are exceedingly fragile and subject to sudden implosion.

    What I’ve been trying to get at in my comments is why things are this way and what can be done to structurally change them in the longer term. Here I still have differences with you.

    To the extent these firms are subject to catastrophic collapse, it’s a profound indictment of their structure. Amongst other things, the prevalence of short-term funding was taken to extremes, and may well still be far beyond reasonable levels. We both agree, I think, that this must change, as must the degree of general interconnectedness.

    The deeper question is whether the change should come through “very intrusive” regulation, as you suggest, or whether an appropriate structure might ensure self-interest (and good old-fashioned fear) on their part would in time do the greater part of the regulator’s job, which is my view. And I think Volcker’s.

    Again, as I said earlier, please accept that I’m setting aside the practical difficulties of getting from here to there. This whole discussion, for me, is about principles and a very long-term goal we should be aiming for in terms of financial markets structures. Once a general destination is agreed, that in my view is the time to start discussing how best to get there.

    That being so, I still think a structure where all these capital markets players know the cavalry won’t be coming over the hill if they get in trouble would work wonders. It would entirely change the way they fund themselves, and the way they operate. Their borrowings would necessarily become much longer term and the creditors providing the funds would no longer be passive. Counterparty risk would become a soberingly real consideration for all participants and be margined and managed accordingly. And so on. A far less leveraged and much more stable sector would, in my view, emerge out of all these changes.

    Tighter regulations would still be necessary in some cases (and should certainly be held in constant reserve), but I think once the markets really became convinced there was no safety net for these sectors, behavioural problems would shrink markedly.

    That’s the alternative vision I’ve been (no doubt quite inadequately) trying to put forward, and the sort I also think Volcker has in mind.

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