If Economics of Contempt and Yves Smith see something the same way I did, there's probably something to it, as we seldom see eye-to-eye on much. That something is the Volcker plan, and Paul Volcker's defense of it in today's New York Times. The essence of the critique is that the plan's focus on deposit taking institutions is overly narrow, and Volcker's assumption (as set out in his oped) that non-bank "capital market" institutions don't pose a systemic risk is just wrong. As I noted in "Don't Bank on It" and the follow up post, investment banks and hedge funds and foreign banks not subject to the plan's constraints will take advantage of the profit opportunities foreclosed to banks by the plan. These institutions will grow large and leveraged, and even though they are not beneficiaries of deposit insurance, they will be so enmeshed in the financial system that in the post-Lehman environment it is unlikely that governments would forego a bailout were they to run into trouble. Knowing that, lenders will be willing to finance them at rates that do not reflect their actual risks, and they will grow to large and risky.
Here's the way Smith puts it:
The consequence of this system of "market based credit" is that those markets have significant scale economies (network effects, high minimum scale required to be competitive, etc.). The result is a comparatively small number of firms have made themselves crucial. The Bank of England in its April 2007 Financial Stability report noted the importance of certain firms it called "large complex financial institutions" and deemed them to be important not simply due to their size, but also their crucial position in certain markets. Its list then was:
ABN Amro, Bank of America, Barclays, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman, HSBC, JP Morgan Chase, Lehman, Merrill, Morgan Stanley, RBS, Societe Generale, and UBS
Of course, that list is somewhat shorter now, but a bigger issue remains: if you tried breaking the capital markets operations of these dominant firms up, those businesses would tend to evolve back into a concentrated format. And it is these origination and trading operations that make them too indispensable to fail.
In reading Volcker's op-ed, he completely ignores the 800 pound gorilla in the room, that this crisis extended a safety net under these…
