By Perry Mehrling, a professor of economics at Barnard College. Originally published at his website
A month ago, the Volcker Alliance issued a report intended to address a central issue that had been purposely left to one side in the Dodd-Frank reform legislation, namely the inadequacy of the regulatory system that will be tasked with implementing any future financial reform. Titled “Reshaping the Financial Regulatory System: Long Delayed, Now Crucial”, the report got respectful notice in the financial press, but then quickly dropped from sight. (Disclaimer: I am listed in the acknowledgements, and I did attend and speak at a small meeting with Volcker and his team in New York last January, but my topic was the Volcker Rule, not the regulatory system.)
That’s a shame. The report is short, informative, and readable, and deserves more sustained attention. Even the appendices are short, careful, readable summaries of much longer background research papers. I’m going to assign this report in my on-campus course next fall.
A single blog post today however suggests that attention may now be beginning to be paid. That’s a good thing. Let me now try to push the conversation to the next level.
At first glance the report seems like just one more call for consolidation of a fragmented bank regulatory structure, and indeed it does call for such consolidation under a single Prudential Supervision Authority. But it does much more than that.
Significantly, the new PSA would also encompass “the prudential supervisory functions of the SEC and the CFTC with respect to broker-dealers, swap dealers, DCOs, clearing members, FCMs, and MMFs.” In other words, the goal is to include the key institutional infrastructure of the market-based credit system, aka the shadow banking system, under the same roof as the traditional banking system. (The report includes a handy translation of its many abbreviations in Appendix D.)
This animating goal, to bring the structure of the regulatory system into line with the actual structure of our modern financial system, comes through in other recommendations as well. The recommendations on oversight and surveillance, while focused on protecting from political influence the work of the Financial Stability Oversight Council and the Office of Financial Research (both new entities established by Dodd-Frank), also clearly asserts authority over market-based credit: “the ability to require new or enhanced prudential standards and safeguards on all activities and practices that could pose a threat to systemic stability even if conducted outside the present sphere of prudential regulation.” And the recommendation on investor protection and capital market conduct would consolidate the SEC with the CFTC, in long-overdue recognition that securities and derivative markets are today completely intertwined, indeed substitutes for one another.
Volcker’s concern is that regulatory silos have resulted in “regulatory gaps, loopholes, and inefficiencies”, and that seems obviously true, indeed a cynic might say it is a feature, not a bug. My own concern is the way these regulatory silos have reproduced and reinforced intellectual silos in our understanding of how the financial system works. To Volcker’s call for reform of the regulatory system, I would add a call for reform of the intellectual system, and along much the same lines that Volcker recommends.
The market-based credit system is fundamentally about money market funding of capital market lending, and therein lies the intellectual challenge. Like Volcker’s Prudential Supervisory Authority, we need to bring the infrastructure of the shadow banking system into our intellectual fold on the same basis as the infrastructure of the traditional banking system.
This is not just a matter of appreciating that overnight repo is in many ways similar to a bank deposit liability, though that is a good start. It is also about bringing into intellectual view all the other entities Volcker lists: “broker-dealers, swap dealers, DCOs, clearing members, FCMs, and MMFs”. (Okay, DCO=”derivatives clearing organization”, FCM=”futures commission merchant”, and MMF=”money market fund”.) These are in effect the key market making institutions where prices are formed, both the price of money market funding and the price of risky capital market lending.
Supposing that Volcker’s proposal became law tomorrow, the mere institutional fact of unifying the regulatory apparatus would, I submit, force rapid progress to overcome the intellectual silos as well. The problem though is that, without that intellectual progress, Volcker’s proposal is very unlikely to become law any time soon. We are stuck in a bad equilibrium, where regulatory and intellectual silos support one another. Our challenge is to set our eyes on the good equilibrium, where both the regulatory system and the intellectual system connect with the actual reality of the modern credit system.