Yesterday, Paul Volcker testified about systemic risk and criticized the administration's ideas about financial regulation. Though all of his criticisms weren't exactly convincing, a few were useful. First, he went after the administration's decision to publicly recognize which firms are systemically risky (too big or interconnected to fail) and force them to carry more capital, have less leverage -- making them much less profitable -- and prepare detailed plans to dismantle themselves in the case of failure. He says merely identifying the firms carries with it the implicit promise of government bail-outs and increases moral hazard. Here's the thing: The government doesn't decide if a firm's failure will be systemically risky or not, the market does. For instance, last year we thought Lehman wasn't a systemic risk because it wasn't very big, and when it failed and nearly brought the financial system to a halt, that was a big surprise that required extraordinary and expensive Federal action. But if regulators try to identify those firms, make them act more safely, and explicitly tell them that they will get no help if they fail while requiring them to create a plan for failure, I think that does a pretty good job making clear they won't get a bail out. Volcker's solution seems to be making sure bailouts are available only for commercial banking, whatever the consequences, which could lead to a situation where a future AIG takes down the banking system, and even then he concedes that some kind of regulator will need to identify institutions that are too big to fail and set rules for them, so it even gets a bit incoherent in the end. Volcker also said that commercial banks shouldn't be allowed to have private equity or hedge funds in-house, or have proprietary trading desks. This is a good idea, and it ought to be in the plan. But Volcker also said, weirdly, that the Fed isn't getting enough power under the administration's plan, which would take away many of the Fed's regulatory powers in other areas while making it the main regulatory of systemically risky firms. The administration's plan has come under fire from all across the board for giving the Fed too much new power, so I don't know quite what Volcker is complaining about, except that Treasury would get additional checks over some of the Fed's actions to give the institution more political accountability. On a side note, progressives often complain about how Volcker is excluded from the administration's deliberations. But Volcker is a creature of the Fed and the banks, having shuttled bank-and-forth between them for his entire career. And though his policies at the Fed brought us out of stagflation, they also involved a tough recession that had populists up in arms in Washington, D.C. While he's certainly advocated smart ideas, it's funny that the critics of banks and the Fed seem to forget everything Volcker did prior to, oh, 2006. Not say that Volcker wasn't right; though his decisions were hated at the time, they are now considered sensible -- might be some parallels with the bank bailouts in the future.
-- Tim Fernholz
