Volcker Wants Smaller Banks

Paul Volcker, former head of the Federal Reserve (1979-1987), currently serves as chairman of the Obama Administration’s newly formed Economic Recovery Advisory Board. Volcker is widely credited with ending the stagflation crisis of the 1970s through aggressive government action and was allegedly fired by President Ronald Reagan when he refused to go along further with his administration’s deregulatory efforts.

Since the start of the financial meltdown, Volcker has been critical of banks, arguing that more regulation of the sector at large is required while commercial banks mustn’t engage in riskier activities as proprietary trading, private equity and hedge fund investments. He recently reiterated his position in an op-ed in The New York Times, writing about the reforms he believes necessary: among them, “appropriate capital and liquidity requirements for banks; better official supervision on the one hand and on the other improved risk management and board oversight for private institutions” as well as “a review of accounting approaches toward financial institutions.”

Yet “some central structural issues have not yet been satisfactorily addressed,” notes the former central banker. “A large concern” of his “is the residue of moral hazard from extensive and successful efforts of central banks and governments to rescue large failing and potentially failing financial institutions.” As Nicole Gelinas previously argued though, it is precisely these efforts that have “hammer[ed] home the idea in bondholders’ minds that the firms […] are too big to fail, that the government will bail them out again the next time they screw up.”

Volcker seems to agree. He complains that, “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” which makes them less averse to taking risks they otherwise wouldn’t. Volcker’s solution: “more effective fail-safe arrangements.”

The most effective of “fail-safe arrangements” is, however, no arrangement whatsoever except the workings of the free market. If it weren’t for government bailouts and guarantees, which spiked last year but have in fact been in place for many decades, most banks wouldn’t have engaged in the sorts of businesses which led them to the brink of bankruptcy in the first place. The ones that had nonetheless, would have failed eventually, leaving plenty of healthy companies to claim their place on the market.

Volcker’s, and the Obama Administration’s, intend is to downsize banks to prevent an “individual failure” to be “so destructive for the economy.” The truth is that an individual failure hardly ever is. The reason that the financial sector is now blamed for causing the crisis in the first place is because many banks led government incentives and guarantees influence their policies. The result? Dismal failure.

Not according to Volcker though. He argues that the “implied moral hazard” of providing a public safety net for private businesses “has been balanced by close regulation and supervision.” Yet regulation and what is deceivingly labeled “supervision” are the moral hazards we are talking about, sir!

Unsurprisingly, what is proposed is more regulation, in the form of restricting the amount of capital and leverage which a “limited number” of investment banks and perhaps insurers would be allowed to hold. This implies the punishment of success: whenever a bank is “too big”, it becomes subject to special regulation which curtails its freedom of enterprise.

The former Fed chairman does appear to suggest an interesting reform of bankruptcy law to prevent that banks should ever be deemed “too big to fail” again: the concept of a “living will” which would not protect stockholders and management but assure that creditors would suffer only “to the extent that the ultimate liquidation value of the firm would fall short of its debts.”

Volcker proposes the creation of an “appropriately designated agency” that “should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure.” Who determines when a bank is “systemically critical”? The new “resolution authority” supposedly. This doesn’t appear to entail “structural reform” therefore. Rather, once again, the financial sector would fall victim to the arbitrary decisionmaking of bureaucrats who, by whatever standard, determine whether a bank is “too big” for their liking — effectively not solving anything.