Parsing Volcker

By Felix Salmon
September 27, 2010

Paul Volcker should carry Damian Paletta around with him wherever he goes. Volcker’s speech to the Chicago Fed on Thursday, delivered, as Yves Smith says, “in a moderate, occasionally perplexed tone” was not exactly gripping stuff. But Paletta saw something blistering there and well done to him for doing so. Paletta’s Volcker might be a bit more forthright than the real-world Tall Paul (I’m reminded, once again, of Kripke’s Wittgenstein), but that just means that we’ve now created the best critic yet of the national and international financial architecture: the natural authority of Volcker, distilled by Paletta into its purest and most powerful form of critique. By which I mean, a numbered list!

So, to take the items in order. This list, it turns out, goes to 13:

1) Macroprudential regulation. I love the way that Volcker dismisses macroprudential regulation, just by waving at the prefix it uses: if macroeconomists can’t agree on anything, he reasonably asks, why on earth should we believe that macroprudential regulators will ever have enough certainty about anything to actually do something? It’s a very good question.

For instance, macroprudential regulators are almost certainly going to do nothing about the enormous pool of credit default swaps that has appeared out of nowhere over the past decade or so, despite their central role in the downfall of AIG. If I was a macroprudential regulator, I’d do the same thing — nothing. But clearly it would have been a good idea to prevent enormous contingent CDS liabilities from building up on the balance sheets of AIG and other too-big-to-fail institutions. Is there any reason to believe that tomorrow’s macroprudential regulators will be able to see such dangers and head them off? No.

2) Banking. Investment banks became trading machines. This is a slightly odd critique: haven’t a lot of broker-dealers always been investment banks? If anything, we saw the rise of a new genus of trading machines (think Citadel) which weren’t banks at all. And so long as there are markets, someone is going to have to play the role of trading machine and liquidity provider. And those firms are always going to be systemically important, whether they’re investment banks, commercial banks, hedge funds or some new animal entirely.

3) Financial system. “The financial system is broken. We can use that term in late 2008, and I think it’s fair to still use the term unfortunately.” This can be read as a fundamental critique of Dodd-Frank and Basel III as not going far enough — although it could also be a simple statement of fact, reflecting the severity of the 2008 crisis and the amount of time it will necessarily take to adjust to a new normal. Yes, the mortgage market is broken today, far too reliant on government finance, but there’s no simple reform which can fix it overnight. You want a world where banks will happily lend against houses and hold those loans on their balance sheet? We’re not going to get there for years yet, no matter what legislation is passed in Washington.

4) Business schools. Duh. The latest news on that front seems to indicate that they’re places you go to ensure you don’t learn anything at all.

5) Central banks and the Fed. The Great Moderation was a huge headfake for central bankers globally: it was a warning sign they took as an indication that they were doing everything right. And tomorrow’s central bankers aren’t going to be any smarter. As for what Volcker calls “a certain neglect of supervisory responsibilities” — well, that’s one way of putting it. Another is to say that the Greenspan Fed was actively hostile, on an ideological basis, to the concept of bank supervision. And those ideologues haven’t entirely gone away.

6) The recession. Is not over, the NBER notwithstanding. The real recession is seen in the unemployment rate. Which is something Volcker intuitively understands. Because we need to get unemployment down fast, lest it become structural.

7) Council of regulators. “Potentially cumbersome”, says Volcker, and he’s quite right. It can, theoretically, be very effective. But the base-case scenario is that it won’t be. The new architecture put in place by Dodd-Frank is necessary but it’s not remotely sufficient.

8) On judgment. Regulators can’t be expected to have excellent judgment. But if they don’t, they can end up causing more harm than good.

9) On procyclicality. This is a subset of the judgment issue. Taking away that punchbowl is never easy and Dodd-Frank hasn’t made it visibly easier.

10) Risk management. Is something every big firm says they’re very good at — which is a statement it’s almost impossible to test. Of course they know that tails are fat. But what do they do about it? And how can regulators judge risk managers? Ultimately, they probably can’t.

11) Derivatives. “The creation of derivatives has far exceeded any pressing need for hedging”, says Volcker. Which is true, although nobody really knows what that means. The creation of stocks would far exceed any pressing need for equity investing too, if anybody could simply create them out of thin air in a zero-sum game, the same way they can with derivatives. If financial instruments are free to create, then a lot of them will be created. Is that harmful? Well, it could certainly use some regulatory scrutiny and probably a lot more exchange trading.

12) Money market funds. This is a really good point: they’re essentially checking accounts, but they’re run by entities which aren’t regulated as banks. Every one of these funds would be devastated by a “run on the bank”. And no one seems to be worried about that. Certainly there’s nothing in Dodd-Frank to address it.

13) The Fed and Dodd-Frank. Volcker is right that the Fed hardly covered itself in glory the last time around, but it’s still the best bet, in terms of regulatory authorities, to prevent a crisis next time. I wouldn’t go nearly so far as to say that it will probably succeed. But its chances of success are higher than any alternative, just because of all the information it gathers on a daily basis, especially in New York. Can the New York Fed ask the right questions and send the answers to Washington, where they will be acted on? I wouldn’t bet on it. But it’s the best chance we’ve got.

One comment

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Re: 2) Banking – part of the problem is that the investment banks became banks too! LEH had large, chunky, mismarked commercial real estate positions.

Re 10) Risk Management, I commend to your readers two papers by the Senior Supervisors Group that detail their findings on Risk Management.

Observations on Risk Management Practices during the Recent Market Turbulence
http://www.newyorkfed.org/newsevents/new s/banking/2008/rp080306.html

Risk Management Lessons from the Global Banking Crisis of 2008
http://www.newyorkfed.org/newsevents/new s/banking/2009/ma091021.html

Tail risks are generated not by ex-ante observed high risk exposures (banks have an incentive to keep those positions small and watch them closely) but rather by ex-ante observed high quality exposures (which may be large in size and “presumed” safe – witness “super-senior” exposures, which were supposedly better than Aaa, or Enron as a fallen angel).

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