During yesterday's testimony on the Volcker rule, we heard this exchange:
Richard C. Shelby of Alabama, the senior Republican on the banking committee, asked how regulators would discern “excessive growth” in a bank’s share of market liabilities.
“Well, I think — the only answer I can give there is like pornography: You know when you see it,” Mr. Volcker said, paraphrasing the late Supreme Court Justice Potter Stewart. Many in the room laughed.
Mr. Shelby noted that the regulatory overhaul approved by the House in December already contained provisions permitting regulators to restrict speculative trading by banks.
But [former Fed Chairman Paul Volcker] said those provisions should not allow discretion. “The regulator ends up in an impossible position during fair weather,” he said. “Because all the banks will say: What are you talking about? Nothing is happening. My trading is perfect. We haven’t had any big losses. You can’t restrict us. I’m going to go down to the banking committee and tell them you’re going to be unfair and unreasonable.”
He added: “If you just take away the word voluntary in the House bill, I think you've got a better bill.”
This is a problem I've discussed before. It's definitely better to make rules by statute, especially on scope issues, because regulatory discretion often means no regulation. But you can't build legislative language to limit size around "you know when you see it," and there has yet to be a good measurement of how to really enforce a size cap. I think the administration's idea about limiting liabilities by market share a la deposit caps has promise, but they have yet to really enunciate it; I think other ideas about capping asset size by percent of GDP paints with too broad a brush. We really need better leadership on this issue.
Ironically, in the hands of good regulators, the Kanjorski amendment would be much, much more powerful than the Volcker rule simply because the discretion is so broad -- regulators could dismantle almost any financial firm they liked if they thought it was getting too risky. Meanwhile, the Volcker rule has pragmatic appeal because it eliminates discretion, but that makes it much narrower -- while commercial banks would be less risky by dint of the scope limits, investment banks and insurance companies (i.e. Bear Stearns and AIG) would be virtually unaffected. It's the paradox of regulatory reform, and why some kind of hybrid between the two -- basic statutory rules with regulatory discretion going further -- is probably the best solution.
-- Tim Fernholz
