The Growing Consensus: Paul Volcker Doesn't Get It

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 global trading operations. More important, the industry recognizes full well how it is now situated. These origination and market-making operations will not be allowed to seize up. Before, they merely played with other people's money. Now they play with other people's money and a guarantee. Having the officialdom say it ain't so or pretend it is working towards a solution when it does not yet have one does not fool anyone who understands the real issues.

Put differently, governments' inability to commit credibly not to intervene to save big, interconnected firms is a huge gravitational pull that encourages the coalescence of such massive entities.  Deposit insurance is not the key problem.  Indeed, deposit insurance can encourage the formation of a lot of small, risky institutions that may pose a systemic risk collectively (see the S&L crisis); it is the inability to precommit not to save the big but failing that encourages the evolution of too big institutions.  And saying that deposit taking banks cannot engage in a certain type of potentially risky activity will primarily foster the development of big firms that don't take deposits, but engage in this risky activity.

I think that Volcker's main problem is that he has an anachronistic, and perhaps nostalgic, view of the financial system.  Putting aside the point of whether it is desirable to restore the financial system of the days of Leave it to Beaver, it is clearly impossible to do so.

Maybe all this is moot.  If this FT piece is to be believed, the Volcker plan is DOA in the Senate:

A proposal by former Federal Reserve Chairman Paul Volcker to limit bank's proprietary trading will be either be dropped or significantly modified in the Senate, lawmakers and staffers told dealReporter.

Senate Banking Committee ranking member Richard Shelby (R-AL) said he opposes the so-called Volcker rule and the Obama administration's call to levy a USD 90bn tax on banks. His comments come as House Financial Services Committee Chairman Barney Frank (D-MA) predicted the proposals outlined by President Obama could be law within six months.

Speaking to this news service on Thursday, Shelby said if Democrats push forward with the proposals they risk unravelling much of the bipartisan support already reached regarding the passage of financial regulatory reform in the Senate. Shelby said that the Obama administration risks losing Republican support for the bill if they begin to "politicise" the issue.

However, Shelby said he expects to hold a meeting with Banking Committee Chairman Chris Dodd (D-CT) regarding the way forward on regulatory reform in two weeks time. A Democratic banking committee staffer confirmed that the meeting between Dodd and Shelby will be critical as Dodd needs to determine the level of bipartisan agreement and the timing of bringing the bill through committee and on the Senate floor.

With the election of Republican Scott Brown to the Senate, the Democrats no longer have the necessary 60 votes to force through a Regulatory Reform package, and any bill will need at least some Republican support to pass. A Dodd staffer said the senator is likely to quietly drop or modify many of the recommendations in the Volcker rule to ensure Republican support for regulatory reform.

"Chris is retiring so he wants to end his career with an important regulatory reform bill and he wants to make the bill bipartisan," the staffer said. "He is not going to risk bipartisan support to make the White House happy."

. . . .

Senator Mark Warner, a Democrat on the banking committee from Virginia, also said he has concerns regarding elements of the Volcker rule, many of which are already being dealt with by the committee. He said that one of the problems is in the definition of what constitutes proprietary trading and that regulators should be more proactive in determining what constitutes excessive risk taking by financial players.

Warner also said that the prospective Senate version of the Kanjorski amendment passed by the House also includes using capital adequacy standards to reign in excessive risk taking by financial institutions and that such an approach gives regulators greater flexibility. [Pet peeve alert: it's rein in dammit, not "reign in."  It's pretty bad when the editors of one of the world's largest newspapers, and a British one no less, doesn't know the difference.]

But apparently JP Morgan Chase isn't taking any chances about the Volcker rule (as Surya first noted in the comments over the weekend):

J.P. Morgan Chase & Co. is reconsidering its interest in acquiring the North American operations of RBS Sempra Commodities but remains in talks to buy the firm's European metals and energy trading operations, people familiar with the situation said Monday.

The change in sentiment is tied to J.P. Morgan's concerns about new proposals by President Barack Obama that could put a kink into any acquisition, as well as the notion that the North American natural gas- and energy-trading business overlaps with some of the bank's existing operations.

The new proposals from the Obama administration, issued last week, could force a large commercial bank like J.P. Morgan to exit any proprietary-trading businesses like those up for sale.

A good illustration of the effects of policy uncertainty.