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Marketplace Scratch Pad

Listen to the man

Scott Jagow Sep 24, 2009

Former Federal Reserve Chairman Paul Volcker testified to Congress today about President Obama’s plan for regulating the financial industry. Volcker is a smart cookie, and he’s not afraid to challenge conventional thinking.

Read Volcker’s entire testimony here, but a few things stand out. First, he said Obama’s plan keeps the “too big to fail” doctrine in place, and that’s a huge mistake:

However well justified in terms of dealing with the extreme threats to the financial system in the midst of crisis, the emergency actions of the Federal Reserve, the Treasury, and ultimately the Congress to protect the viability of particular institutions – their bond holders and to some extent even their stockholders – have inevitably left an indelible mark on attitudes and behavior patterns of market participants…

What all this amounts to is an unintended and unanticipated extension of the official “safety net”, an arrangement designed decades ago to protect the stability of the commercial banking system. The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted. Ultimately, the possibility of further crises – even greater crises – will increase.

Volcker says commercial banking and investment banking must be separated:

The point is not only the substantial risks inherent in capital market activities. There are deep-seated, almost unmanageable, conflicts of interest with normal banking relationships – individuals, businesses, investment management clients seeking credit, underwriting and unbiased advisory services. I also think we have learned enough about the challenges and distractions for management posed by the risks and complexities of highly diversified activities.

Three letters — AIG. Here’s Volcker’s solution for non-bank financial companies like that:

What is envisaged is appointment of a “conservator” or “liquidator” to take control of a financial institution defaulting, or in clear danger of defaulting, on its obligations. Authority should be provided to negotiate the exchange of debt for new stock if necessary to maintain the continuity of operations, to arrange a merger, or to arrange an orderly liquidation.

That would be instead of going to a bankruptcy judge.

Finally, he believes the Fed, not the Treasury should be the lead agency of financial oversight. He says the Fed should not be stripped of power:

Quite simply, it is the Federal Reserve that has (surely should have) the independence from political pressures, the prestige and the essential qualifications of experience to serve as overseer of the financial system. It should have ample authority to obtain needed information from both other regulatory agencies and from financial firms, to work with those agencies in identifying weaknesses in market institutions and practices, and, if necessary to call for changes in regulatory practice.

I’m still worried about giving the Fed too much power. But Marketwatch says Volcker’s right:

Plenty of members of Congress argue that the Fed didn’t do its job in recent years. But it’s doubtful there is a single statement in the Congressional Record urging higher rates to pop the developing asset bubbles.

And however bad a job Greenspan’s Fed may have done, it wasn’t acting alone. For instance, Congressional meddling and oversight of Fannie Mae and Freddie Mac was clearly a major contributing factor to their collapse and subsequent multi-billion dollar bailouts.

Whether or not you agree with Volcker’s assessment of the Fed’s role, his ideas are a valuable part of the discussion, particularly his warning about naming any company too big to fail.

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