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Speeches and Papers

Essential Elements of Financial Reform

by Paul A. Volcker, Chairman of the President’s Economic Recovery Advisory Board

Transcript of speech delivered at the Peterson Institute event "Volcker on Essential Elements on Financial Reform"
March 30, 2010


When we agreed to this [event], I had not assumed I was going to have laryngitis on this great occasion of ours. In any event, those of you who know Fred know he has a list for every speaker. Every speaker is at the top of some list. I thank you for bringing up that ancient history, and I say ancient history advisably.

I remember when I was teaching that any event that happened before the lifetime of the students in college, anything that happened more than 20 years ago, was ancient history. They kind of mixed it up with the Second Punic War or something. So I'm glad to have that little reminder of what happened some years ago. I don't remember when we agreed to this occasion, Fred, but I think I'm sure it was before we had the Senate bill, and things have moved a bit in these last few weeks.

I think one way or another, the so-called Dodd Bill has touched upon the essential elements of financial reform, and it's true that most of that bill parallels what was in the House bill. So they may have given answers to some particular questions but it seems to me—and then I think we need some further debate—that we have a framework for getting an agreement this year, and I think that it's reasonably quite optimistic that that will come about with a reasonably good bill. I feel more optimistic now than I would have felt a month or two ago, given what's been happening in the Senate and elsewhere. And given the really poisoned political atmosphere in Washington, it's hard to be optimistic about anything. But I do think we have a promising possibility of getting an agreement here.

I'm also aware that I want to be optimistic about this, so I am conscious of the fact that the Dodd Bill includes something called the Volcker Rule. And at my age, I want my name to be inscribed in a law some place, so I have a particular interest in this thing. But I really want to start out by talking about a a much broader question, a much broader setting for what's going on, and it's come to bother me, and I'm not alone. But it does seem to me that this broader question that I have in mind needs to underlie our approach to reform, and it's really been a neglected question. And in terms of some consensus on the answer, it's going to be hard to get the kind of reform we need. Now, let me just describe what I have in mind.

What's happened to the American economy in this century? Well, we've had economic growth, but there hasn't been anything very vigorous; and in fact when we had the crisis, what growth we had was reversed for a while. It was not a brilliant performance for the American economy. And one sector of the economy of course, we had fantastic growth, and that's our financial sector: growth in compensation, growth in profits. And when we went over the data—and I've looked at it a little bit and some of it was kind of puzzling—I wondered from what source you look at. But I think it is true that something between 35 percent and 40 percent of all the business profits in the United States in recent years before the crisis came from the world of finance. And if you look at the value added figures, which are a little puzzling, if you look at the nearest approximation to what you would think of as finance, finance value added went up by more than 50 percent over the past 10 or 15 years.

Now, if you look at it, I believe the figures of the valued added in the finance industry was equal to the value added in the entire manufacturing industry in the United States, which somehow raises my eyebrows a little bit. At the same time, incomes of the average wage earner in the United States haven't budged in this century; and that was, again, before the crisis. They haven't really budged in real terms. And it's kind of odd that if we decided that we can have an increase in productivity and an increase in growth, the average wage earner is going to benefit. That's the way the economy works. This century then there's going to be quite a lot of catching up to do if we could get back to what might be considered a more normal relationship.

The question that really jumps out to me is, given all that data—as well as the enormous gains in the financial sector and compensation and in profits—we only reflect the relative contributions that that sector has made to growth and human welfare. There's another way to raise the same question really. Look at the contribution of finance to the economic welfare. At least it raised the question whether all that financial engineering didn't contribute to the underlying imbalances in the economy that were so evident. The underlying imbalance characterized mainly by the lack of savings in the United States as the decade approached, and you had this feeling that people were maintaining their consumption patterns when incomes weren't rising by eliminating their savings, and they could do this under the shield in part of rising housing prices as the decade approached.

When you look at those phenomena, how could that go on so long in the way that was, I think, in the end certainly unsustainable without a lot of financial engineering that provided the credit for the consumption to persist in the face of lack of savings and relatively slow economic growth? Or did the world of finance sustain that imbalance for a long time and arguably, at least, let us ride to a very steep cliff as the financial system unwound? The advantage of old age is you can make comments half off the top of your head and reflect the ill instincts without the exhaustive economic analysis characterized by the Peterson Institute. And I have been known to ask the question before whether all the value added was really a reflection of value added in finance or was it really a reflection of outlandish compensation and trading profits that really has little contribution to human welfare.

Now, I think it is fair to say that you can detect now a different mood in the intellectual climate as well as from some grumbling old men. There are changes going on and there are questions being asked as to whether the legendary financial emperor really had any clothes. And I want to suggest to you one piece of evidence there. You may recall—some of you or all of you—the chairman of the British Financial Services Authority made a remark that wasn't quite offhand six months or so ago that suggested that the trading activities of "banks" (and I quote)—he was using banks in a broader term than commercial banks—he raised the question whether all that trading wasn't socially useless. And that was the same point—he raised the question as to whether something like the Tobin tax might be appropriate to put a little sand on the wheels. Now, I'm delighted to see this because you don't have to look to me to [ask] the questions.

Th[is] is extremely sophisticated, thoughtful financial regulation. And he has now come up with—just a few weeks ago—a rather long lecture where he raises the question at the start, "Did I overstate the case when I made these comments about the social usefulness of trading and financial engineering? Let me look at the thing more closely and carefully." And this is a lecture that goes on—30 or 40 pages of very closely typed text. I really encourage you to get a hold of the essay because its conclusion—I don't think I misstate his conclusion, it was a very complicated long lecture—that the benefits of financial innovation had been at the least hugely overstated.

Now, I think the implications for the financial reform are real. He states one of those implications as having a bias, he believes, in reforming the system—a bias toward conservatism. I, not so incidentally in that area, was interested that he does have a passing comment that the extent to which commercial banks are involved in proprietary trading raises questions. So I interpret that as support for my position, even though it was a little more mildly stated.

I have arrived at the idea, as you probably know, of a rather strict prohibition of proprietary trading by commercial banks as appropriate. But I arrived at that position from a rather different but I think a complementary angle. I start with the simple proposition that commercial banks for a long time have been provided with special support and protection. On the one hand, access to the discount window of the Federal Reserve, deposit insurance for when they get in trouble, those protections tend to be extended, and the quid pro quo, of course, is substantial regulation. And that's true in most countries, all countries rightfully. It's also true that the relative role of banks in financial intermediation has declined in the last 20 or 30 years. But nonetheless, it remains true that small and medium-sized businesses are very fully dependent on bank credit. So, if the commercial paper market, which has been removed presumably from the banking system where the commercial paper market exists because [of] its backstop by commercial banks, and it's also true of parts of the mortgage market, and both businesses and individuals are totally dependent upon efficient and effective payment services, and those are in effect the monopoly of commercial banks, those services can get rather sophisticated, nationally and internationally.

So, I draw from that, as banks are essential and protected depositories, they have a certain stability in their funding, which was demonstrated in the recent crisis. They are still the transmission belt for monetary policy, and it's understandable that no country permits large, systemically important commercial banks to disappear into an abyss of sudden bankruptcy. That's been true, not just in response to this crisis but it's been true earlier in the United States and elsewhere, where the great doctrine of too big to fail originally implied just the commercial banks. I think that word "too big to fail" kind of exaggerates the situation. When the government comes in with big support, the stockholders and managers may feel like it's failure.

But the overwhelming factor of the recent crisis was that creditors were largely protected and government support—and here is where we get to the real point of my concerns—government support was provided to nonbanks in actually much more radical ways than to commercial banks, to investment banks, to the world's largest insurance companies, and to the commercial paper market itself. Money market mutual funds, their very existence is dependent upon regulatory arbitrage, where if they got in trouble, we'll protect it. Now, the result is moral hazard gets large. There is an expectation that very large and complicated financial institutions will not be allowed to fail. Creditors, managers, even stockholders need to be protected in a time of crisis. And unless that conviction is shaken, the natural result is that risk taking will be encouraged and, in fact, subsidized beyond reasonable limits and we may be at it full speed to the next crisis some years ahead. But that seems to me to really be the core challenge of financial reform in the United States and elsewhere as well.

I do not believe that we can and should generally restrict proprietary trading or its various manifestations in the form of hedge funds or private equity funds. But what does make sense is to combine those more speculative activities—activities that don't imply any continuing commitment to customers, to institutions that can creditably be denied special support in a time of crisis. It should be clearly understood that it would be private interest, not taxpayers' funds, that would be at the risk of loss in those nonbanking institutions.To support that proposition, it seems to me there is a clear need for a so-called resolution authority that's provided both in the Dodd Bill and in the House bills. It has similar approaches abroad and [is] strongly proposed and supported by the [US] Administration.

A key element in that approach is to provide clear legal authority for some designated agency and in the Dodd Bill, it's the FDIC—acting with due process with approval by various arms of the government to take over a failing financial institution, the failure of which would have highly disturbing systemic implications. The key is that both existing stockholders and management would be removed. Creditors would be dependent on resolution of their claims with appropriate priorities. In other words, creditors would be at risk. Working capital might be provided to maintain continuity of operations in the short run but ultimately, the failing firm should be liquidated or removed in whole or in part; it is a death sentence not a rescue in the hospital.

The situation with respect to commercial banks seems to be different. They do provide essential services, and there's enough variety in those services for them to be potentially quite profitable. They are protected; they are heavily regulated. There is no need economically or otherwise for them to become deeply involved in proprietary activities. Activities that, in fact, may often outright cross purposes with their fiduciary responsibilities, conflicts of interest that are very difficult to resolve.

I've been interested in John Meade, a former chairman of Citibank—a bank that's been known to have recurrent difficulties from time to time—and he has become quite vocal in this point, noting that the responsibility of building and managing one of the largest and most complex banking organizations, speaks eloquently to him of the assiduous and essentially divisive implications of combining in one institution the different cultures of proprietary trading with commercial banks. He deals with a point, I think, that has much proven potential.

But I understand there's a strand of opinion in financial markets that says in effect, "Will all hedge funds now, treat us all alike, regulated essentially by size and interconnectedness, not by activity?" But unless we really want to extend the Federal Reserve's liquidity facilities and deposit insurance, via a commercial bank license, to any huge financial institution with a clear implication of government's support in time of crisis: I think not. Rather, let commercial banks be commercial banks, concentrating on continuing customer interest. If that strikes you as a step back, let me simply argue that it is a step back to a safer, more productive future. The sense of this is let us not open up a tent of public support widely to any complicated financial institution that can get in trouble and then prohibit banking license.

If we commit banks to do proprietary trading of various sorts and say we're going to protect them, we have no argument against the nonbank institutions that [do] proprietary trading and want government protection, too. So, if we are going to protect everybody when they get in trouble, we better make some distinctions from the start. Now, among other essential elements of banking reform, that ranks high on the list for assured financial settlements of derivatives. This is an area where I'm not going to claim any technical capacity in credit default swaps. It doesn't seem like totally ancient history when I was chairman of the Federal Reserve, but I assure you it was well before credit default swaps were even invented, and it was well before subprime mortgages had any importance whatsoever. And I don't have the technical capacity to judge the particulars of all these new developments, but let me say that I am very wary of the pleas in the market to freely permit a large volume of customized derivatives beyond official oversight. It seems to me it is precisely those kinds of derivatives—highly engineered, highly opaque—that tend to get us into trouble.

Now, the rapid rise of derivatives, in particular credit default swaps, emphasize the importance of establishing responsibility for broad oversight for both financial institutions and markets. So again, both the House and the Dodd Bills provide for such authority. They do it in somewhat different ways, but it's there. And I must confess, I am almost skeptical myself about the efficiency and effectiveness of a council of regulators who exercise that responsibility, given their differing perspectives to their institutional concerns, but that's a matter of fine tuning. The function is set out, and I think it was more important [that] the distinction be moving away or supplementing the traditional supervisory approach that looks at institutions individually, to an approach that takes more account of their interrelationships and the market developments that may not be so important in any particular institution but certainly give you a big problem: namely, credit default swaps, or subprime mortgages, to take two recent examples.

Now, I am conscious that in mentioning three or four essential elements of reform, I said nothing about top rule liquidity requirements, leverage restrictions, efforts to reduce the equality of some regulatory approaches, and not least, the importance of international consistency in supervisory approaches. I'm not against any of them. They're important matters but they do lie within the discretion of regulators and supervisors. That does not take new legislation. With rare exceptions, they are matters of continuing discussion in Basel and elsewhere. But I also know from my own experience, and since then, there are no easy answers like telling supervisors and regulators, "You take care of it."

I would point out the simple fact that, [in] the effort to improve what were considered crude capital standards in my day for commercial banks, so-called Basel I, in an effort to get greater sophistication and effectiveness, they launched an effort to get Basel II, which took more than 10 years, and after it was all completed, the United States decided they didn't want to adopt it anyway. And this kind of thing is almost inevitable when you get a lot of countries together—a lot of experts trying to fine tune the thing and to get agreement. Now, I don't have much doubt right now, but however tedious the discussions that are going on, regulators generally will be taking the more conservative approach suggested by Adair Turner and suggested by one of the other officials and commentators.

I do not believe, however, that we can or should rely on supervisory discretion to maintain the full burden of discipline over time. When things are going well—and this I do know from experience—it is extremely difficult to impose stricter standards, whatever the warnings of a few Cassandras about emerging excesses. It is only after those excesses are confirmed by crisis that strong action takes place, but of course then it's too late.

That's why I think it's important that Congress acts and parliaments act to set out some clear "dos and don'ts" that convey a clear sense of the desired structure of financial markets: the proposed tough resolution authority, the restrictions on proprietary activity by banks, the controls and derivative trading, and the requirement that institutions initiating security sanction maintain a significant part of the risk in [their] own books. All those things fall in the category of world legislation and strict rules are needed.

I think we are all conscious of the potentially explosive implications of a combination of extremely aggressive compensation practice, lapses and mismanagement, and the complexities and opaqueness of the mystery of financial engineering. Regulators, politicians, and independent analysts have all struggled with how to achieve greater discipline. Both the Dodd and House bills take a stab at the problem. One would think that the lessons in the crisis itself would profoundly affect behavior, but I have to tell you I'm left with doubts [about] how compensation practices, directed responsibilities, and institutional mismanagement can be legislated. I have doubts, too, about the lasting influence of destructive efforts by industry groups themselves.

The fact is we have a deep-seated cultural challenge. There's been a loss of professional pride with the sanction of fiduciary responsibility. Greed is good? Well, so the new effort says. The magic of the marketplace will contain and defuse the excesses. Well yes, most of the time in most markets, I think that's true but not, I think, in today's financial markets. We can't turn back to small local institutions, we can't return to partnership responsibilities. We have to build on what we have. Well, all of that does emphasize the importance of strong and respected regulatory agencies and supervisors. They need to be able to [do] their job every day, [equipped] to decipher and analyze institutional practices. They need a degree of independence necessary to act in the face of political and constituency resistance. The hard fact is that the nature of the crisis and the failure to anticipate it, the amounts of public money, and the truly unprecedented involvement in markets necessary to cope with the crisis have, to some extent, undermined confidence in the regulatory system generally.

Elsewhere, I have spoken strongly about the importance in maintaining a strong position in the Federal Reserve in the regulatory and supervisory area. Chairman Bernanke and the Administration have plainly staked out that position. As things stand, both the House and the Senate Committee provide significant and needed authority for the Federal Reserve, and the appropriate corollary has been the need to better focus the regulatory responsibilities within the Federal Reserve and to provide the necessary resources and talent. I realize in this talk I neglected important areas where changes need to be made. I have been involved in accounting standards, more disciplined auditing practices in credit rating in companies, cases in point. It's a long complicated agenda, it's justified only by the dimensions of the problem. Let us remember that as things look a little better now: Our financial system broke down. It is still relying [to] a substantial degree on government support—our economic system was threatened. And as somebody emphasized in another context, we must not let the crisis go to waste. We have a reasonable start in legislation, in achieving international consensus and public recognition on the need for change, so I am hopeful that we will proceed this year and get it done.

Thank you very much.


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