The Ascent of Volcker

Jan 21, 2010 20:30 UTC

So, wow, the Obama administration has reacted very quickly — perhaps too quickly — post the Massachusetts Senate election. After proposing a tax on bank liabilities, Obama is taking an even tougher line, adopting recommendations from Paul Volcker that banks be limited in their size and scope.

Before getting to specifics, it’s worth noting how Geithner and Summers appear to have lost favor. In the preamble to the proposal, Obama mentions neither of them. And when he announced the plan he did so with Volcker and Bill Donaldson standing behind him…Geithner and Summers were off to the side. Could the duo be headed for the exit?

But back to the proposals themselves. Unfortunately they are very vague:

1. Limit the Scope – The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

In his prepared remarks, Obama called this first proposal the “Volcker Rule,”

2. Limit the Size – The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

These are good ideas, but until we see the details it’s hard to offer unconditional support.

The idea behind the first proposal is that since government insures bank liabilities, it must control bank assets. Bank liabilities are insured explicitly via deposit insurance and implicitly, for the biggest banks, via a general too-big-to-fail guarantee. Deposit insurance is the only one of those two that is defensible and its purpose is to protect the integrity of the payments system. Currently banks use this insurance to obtain cheap funding that supports risky side businesses, like proprietary trading.

But how will prop trading be defined? Will banks actually have to split up? Will they merely have to tweak their corporate structure?

As for the proposal regarding bank size, it doesn’t appear that there will be much to it. Banks won’t have to get smaller or even stop growing. Instead the new rules will just prevent bigger banks from making (any?) acquisitions. They’ll be able to continue growing organically. This probably isn’t enough to reduce systemic risk, unless other reforms can successfully reduce risk-taking. (Personally I think we should break up the banks into baby banks the way we busted AT&T into baby bells….so that none is so large as to be impossible to resolve in a crisis.)

It looks a little clumsy, putting out a plan this short on detail. That said, it seems to mark a clean break with the ridiculous policy that somehow protecting the banks protects America.

The real test for Obama’s leadership, by the way, will probably come if a substantive plan like this passes. Forcing banks to make big changes to their balance sheets will surely crimp the economy in the short-run as it makes it more difficult for banks to extend credit.

That’s not a bad thing. Either we do it proactively in order to contain risk, or we let the system blow itself up again. The latter course will lead to more credit destruction of course. But asking people to voluntarily subject to economic pain will be tough. Hopefully Obama sticks to his guns.

COMMENT

The markets resposne is a good sign…it says that this is going to change the way banks make their profit.

The present system stinks. Investment banks getting bank status to get a credit line from the fed then hyper-leveraging their free money to make big bucks. Not a lot of skill to that!

Soros and Volcker are right. You need the right regulation that takes out the moral hazard. Investment banks should get their money from the Private sector and Commercial banks should get their money from the Fed(public). This way the Commercial Banks serve as a firewall between riskless funds and Investment bank speculation. And it forces IBs to speculate carefully because they have to invest a lot of capital and energy to convince investors in their magic. What could be wrong with that? This could be the first good policy from Obama.

As Winkler notes, the sacred cow theory of the financial markets is a lot of bull. A false belief. Because the financial system is not a free market, it is structured by government policy and regulation. That regulation needs to be changed. Adjust leverage margins to reasonable levels and pull the Fed’s capital subsidies from IBs.

This crisis was created by overleverage and the inversion of risk. So, put a cap on leverage and get the IBs back in the business of managing real risk. Simple, eh?

Posted by DrSavage | Report as abusive

Lunchtime Links 12-18

Dec 18, 2009 16:25 UTC

(Reader note: still working on

MUST READStrict framework leaves room for maneuver (Masters/Jenkins, FT) While this subject may seem a little dry, it’s the Basel Committee in Switzerland that will lead the way when it comes to how banks measure capital and how much they need to have. I’ll offer more detailed thoughts on this later today.

Saab to be shuttered (Reuters wire) More creative destruction in the auto industry. In the end, the best Saab could do was sell the intellectual property for the 9-5 and 9-3 sedans…

China central banker says harder to buy Treasuries (Xin/Subler, Reuters) How ironic. The current account deficit is shrinking as the import/export imbalance with China is shrinking. So we’re not stuffing as many dollars down China’s throat which it is forced to recycle into Treasuries. Watch out for calls to buy Chinese so that the Treasury can finance its deficits! ;)

China asset bubbles will burst on inflation (Chen, Bloomberg)

Greenspan backs deficit reduction commission (Ferraro/Sullivan, Reuters)

Harvard swaps are so toxic, even Summers won’t explain (McDonald/Lauerman/Wee, Bloomberg)

Has dark matter finally been detected? (Sample, Guardian)

Another VERY cool zoom out/in CG animation of the known universe (YouTube)

Probably not good on the eyes (imgur)

You’re on the naughty list Jack…

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