Paul Volcker Explains How to Fix Big Banks

We have yet to build adequate safeguards for a modern financial system.

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Former Federal Reserve Bank Chairman Paul Volcker speaks during a meeting of the State Budget Crisis Task Force at the National Constitution Center, Tuesday, June 25, 2013, in Philadelphia.

Last week, former Federal Reserve Chairman Paul Volcker warned us about lingering risks and weaknesses in the U.S. banking system and the political logjam that impedes meaningful reforms. Writing in the New York Review of Books, he cautioned:

The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can't be healthy for markets or for the regulatory community. It surely can't be healthy for the world's greatest democracy, no challenged in its role of political and economic leadership.

Volcker sees two main threats to our banking system: first, our ongoing failure to regulate it adequately in the wake of the subprime mortgage crisis, and second, the development of unrealistic and dangerous expectations for the role of the Fed.

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Problems with Dodd-Frank and its Implementation

Volcker begins by affirming that modern financial markets have lost the ability to self-regulate, and that "market discipline alone" fails to "restrain episodes of unsustainable exuberance before the point of crisis."

Yet, the so called Dodd-Frank Act does not solve the problem, he says. It provides both too much regulation and too little. It's too much because it leaves in place more than six overlapping financial regulatory agencies (the Fed, Federal Deposit Insurance Corp., Securities and Exchange Commission, Commodity Futures Trading Commission, Federal Housing Finance Agency, Office of the Controller of the Currency and Consumer Financial Protection Bureau.) "The simple fact is the United States doesn't need six financial regulatory agencies … It is a recipe for indecision, neglect, and stalemate," he said.

Despite the extensive regulation in Dodd-Frank, the bill is badly compromised by loopholes that prevent it from being fully and effectively implemented. Volcker writes: "The present overlaps and loopholes in Dodd-Frank and other regulations provide a wonderful obstacle course that plays into the hands of lobbyists resisting change. The end result is to undercut the market need for clarity and the broader interest of citizens and taxpayers."

Particular problems remain in implementing the prohibition on proprietary trading by banks that take federally insured deposits and providing adequate transparency and collateral to derivatives trades.

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Even where Dodd-Frank gets it right, the implementation has lagged. Perhaps the most important new position called for by Dodd-Frank, the "Vice Chairman for Supervision," remains unfilled three years after the bill was passed. This key position has responsibility for supervising banks, particularly the systemically-important "too big to fail" banks. The job needs to be filled, and the function needs to properly staffed and budgeted to do its vital work.

Keeping the Federal Reserve Well-Focused

Other threats to the financial system come from recent proposals, from both the left and the right, to change the Fed's mission and make it take direction from other parts of government. Volcker cautions about the current calls to reduce the Fed's independence. Without an independent Fed, incumbent presidents would find it irresistible to stimulate the economy in the months leading up to an election, and the Fed's compliance will kick off waves of inflation that will be impossible to control.

Volcker believes the Fed should focus solely on price stability (as some Republicans argue) and not on the so-called "dual-mandate," a mission to balance inflation and unemployment. He argues that the dual mandate is "ultimately illusory" because keeping inflation low inherently promotes economic growth, and as a result, it boosts employment in the long run. However, Volcker strongly rejects calls to strip the Fed of its ability to supply liquidity in recessions, and implicitly sides with most Democrats in supporting the judicious use of Keynesian stimulus.

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The Path Forward

We can't simply return to the rules of the past, says Volcker. The world has changed too much. Financial markets and institutions are larger, more complex, more interconnected and "more fragile." Hedge funds and other non-banks play a much larger role in the system and regulated commercial banks play a proportionally smaller role. The old regulatory structures will not give us the stability we need in the system and its major institutional components.

Volcker reminds us that at other times in our history we have faced the situation where our financial markets and institutions needed to be redesigned. The last time, in the early 1950's, we were able to transcend political partisanship and institutional self-interest to launch a thorough reexamination and come up with a better plan. Two parallel inquiries were launched, one in Congress, and the other, the Commission on Money and Credit, led and staffed by private sector interests.

Volcker calls for a similar inquiry today, urging leaders from government to convene experts from business and academia, with all the relevant business and public interest groups, and design a system that will serve our complex, highly connected and fragile world. The stakes are too high to do otherwise.

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