“Adam Smith more than 200 years ago advocated keeping banks small. Then an individual failure would not be so destructive for the economy. That approach does not really seem feasible in today's world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.
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. ...
[As for other capital market institutions, few are] "too big" or "too interconnected" to fail. In fact, sizable numbers ... fail or voluntarily cease business in troubled times with no adverse consequences for the viability of markets.
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. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed.”
Paul Volcker, "How to Reform Our Financial System", New York Times (31 January 2010).
http://www.nytimes.com/2010/01/31/opinion/31volcker.html
LW: Paul Volcker (1927-) chaired the Federal Reserve under Presidents Jimmy Carter and Ronald Reagan and is now chairman of President Obama's Economic Recovery Advisory Board. He is providing sensible advice, with international relevance. Government leaders and central bankers everywhere should take note.
DOW: I agree with Larry this is an important article by a very experienced central banker noted for his aversion to inflation and love of fly-fishing.
In this article, Volcker advances several ideas he has advocated for some time and which reflect elements in the proposed bank regulations announced by the Obama Administration last week.
Essentially, and in broad outline, Volcker distinguishes between the banking activities of deposit-taking institutions such as commercial banks on the one hand and those of investment banks, private equity funds, and hedge funds on the other. Under his proposal, commercial banks would be limited to traditional banking services such as accepting deposits, making loans to businesses and consumers, investing in corporate and government bonds, and generating fee-based income by renting safe-deposit boxes. They would be prohibited from engaging in risky activities such as trading stocks, bonds, currencies, commodities and derivatives. Only commercial banks would receive “lender of last resort” support from the Federal Reserve to protect depositors.
Investment banks have traditionally raised capital from investors and engaged in capital market activities such as issuing and selling securities, insuring bonds and providing advice and financial support for mergers and acquisitions. They also engage in the trading of derivatives, foreign currency, commodities and equities. At times, they “make a market” by buying and selling a financial product to earn income on each trade or deal in derivatives by creating complex financial products intended to generate a high return. Other activities include investment management for wealthy individuals and merchant banking were it invests its own capital in a client company. Investment banks frequently have global scope.
Until 1999, commercial banks were not allowed to engage in investment banking activities and investment banks were not allowed to accept demand deposits. In my view, removing the separation between these two kinds of banking activities has proven to be unwise and we should reinstitute it. If we do, commercial banking should be narrowly limited to those kinds of loans and investments which involve minimal risk.
Volcker and others say they want to limit the size of big finance and impose more and better regulation on the financial sector, including greater regulation at the international level. Yet he admits “keeping banks small … does not really seem feasible in today’s world, not given the size of businesses, the substantial investment required in technology and the national and international reach required.” In this situation, investment banks clearly have to be tightly regulated but I for one am doubtful that more regulation by the public sector will make much of a difference. I simply do not believe better regulation by the public sector is possible. We always say we want better performance from government and we never get it. So why should I believe regulation of the banking system by government can really improve?
I would rather put very strong incentives in place to discourage bankers from growing too big in the first place and then, as they inevitably do, start making bad investments as a regular part of their everyday business. To be sure, let bankers make a good living and the banks be very profitable and let them be subject to government regulation. But let us change “the rules of the game” to encourage banks and their owners and investors to be prudent, very, very prudent. As a first step, as Volcker suggests, no bailouts for owners and investors in investment banks and similar kinds of financial institutions such as insurance companies. They are on their own. As a second step, remove limited liability protection from the owners of these banks and, more importantly, from the management of these banks. Let them pay personally when they make major mistakes. Both owners and management should be held liable in their personal capacity to creditors of these financial institutions. If we did this, the banks would not become too big because then the owners and managers would fear loss of control, with its risks to their wallets and their livelihoods.
It would also cause them to think hard about every investment decisions they made. They would carefully evaluate each investment they made and spread the risks they took far and wide and in doing so add stability to the entire system.
I know I would sleep better if the owners and management of these banks were fully accountable for the performance of their banks, even if they wouldn’t rest as well as they do now.
A tip of the hat to Larry for the Tdj.
No comments:
Post a Comment