Legal Commentary

Volker on Financial Reform

By Kenneth Anderson

For those following financial regulatory reform debates, Paul Volker?s NYT op-ed today is must-reading (NYT Op Ed, Paul Volker, How to reform our financial system, January 31, 2010).

The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading ? that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs. Those activities are actively engaged in by only a handful of American mega-commercial banks, perhaps four or five. Only 25 or 30 may be significant internationally.

Apart from the risks inherent in these activities, they also present virtually insolvable conflicts of interest with customer relationships, conflicts that simply cannot be escaped by an elaboration of so-called Chinese walls between different divisions of an institution. The further point is that the three activities at issue ? which in themselves are legitimate and useful parts of our capital markets ? are in no way dependent on commercial banks? ownership. These days there are literally thousands of independent hedge funds and equity funds of widely varying size perfectly capable of maintaining innovative competitive markets. Individually, such independent capital market institutions, typically financed privately, are heavily dependent like other businesses upon commercial bank services, including in their case prime brokerage. Commercial bank ownership only tilts a ?level playing field? without clear value added.

Very few of those capital market institutions, both because of their typically more limited size and more stable sources of finance, could present a credible claim to be ?too big? or ?too interconnected? to fail. In fact, sizable numbers of such institutions fail or voluntarily cease business in troubled times with no adverse consequences for the viability of markets.

What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed ....  ....  To put it simply, in no sense would these capital market institutions be deemed ?too big to fail.? What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital ? and as ordinary businesses in a capitalist economy, to fail.

I do not deal here with other key issues of structural reform. Surely, effective arrangements for clearing and settlement and other restrictions in the now enormous market for derivatives should be agreed to as part of the present reform program. So should the need for a designated agency ? preferably the Federal Reserve ? charged with reviewing and appraising market developments, identifying sources of weakness and recommending action to deal with the emerging problems. Those and other matters are part of the administration?s program and now under international consideration.

In this country, I believe regulation of large insurance companies operating over many states needs to be reviewed. We also face a large challenge in rebuilding an efficient, competitive private mortgage market, an area in which commercial bank participation is needed. Those are matters for another day.  What is essential now is that we work with other nations hosting large financial markets to reach a broad consensus on an outline for the needed structural reforms, certainly including those that the president has recently set out.

Full post as published by The Volokh Conspiracy on January 31, 2010 (boomark / email).