Monday, February 1, 2010

Financial Sector Reform - Volcker's Proposals

Paul Volcker has a nice op-ed in the NYT on financial sector reform. Here are some excerpts:
The phrase “too big to fail” has entered into our everyday vocabulary. It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks.As things stand, the consequence will be to enhance incentives to risk-taking and leverage, with the implication of an even more fragile financial system. We need to find more effective fail-safe arrangements.

...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.
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.

To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new “resolution authority.” Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization.

To put it simply, in no sense would these capital market institutions be deemed “too big to fail.” What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail.
What is essential now is that we work with other nations hosting large financial markets to reach a broad consensus on an outline for the needed structural reforms, certainly including those that the president has recently set out. My clear sense is that relevant international and foreign authorities are prepared to engage in that effort.
I am well aware that there are interested parties that long to return to “business as usual,” even while retaining the comfort of remaining within the confines of the official safety net. They will argue that they themselves and intelligent regulators and supervisors, armed with recent experience, can maintain the needed surveillance, foresee the dangers and manage the risks.

... We need to face up to needed structural changes, and place them into law. To do less will simply mean ultimate failure — failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future.
Volcker has been leading the fight against "too big to fail." While there is merit to keeping banks small, I doubt if this alone will prevent future crises. Volcker and others have pointed out the need to regulate the derivatives market, robust stress tests for banks, etc as part of the package of measures that must be adopted. President Obama has indicated that financial sector reform would be a priority in the weeks leading up to his State of the Union speech. This is one issue that has united Democrats and Republicans alike, so we might see some movement in Congress.

In Ireland, the debate about financial sector legal reforms is conspicuous for its absence. It is incredible that many of the abuses seen here - loans to corporate insiders, for example - were permissible. This sort of cowboy capitalism has no place in a modern legal system. It is imperative that we get the minimum requirements for an efficient system of corporate governance right before we engage with the bigger questions. This window of opportunity for reform must not be missed.