Volcker's Temperance on Regulation

The Wall Street Journal ran a special section on March 30th resulting from its recent conference on financial regulation. Frankly, I found most of it to be either a rehash of ideas already put forth by others, including myself. There were a few highlights of note. One was Peter Fisher's remarks. Another were some quotes from a discussion including noted hedge fund short James Chanos.

And Paul Volcker's observations on changes in regulation. It is on this topic I wish to write today.

For me, the headline is that, despite being associated with an administration that is rushing about demanding excessive regulation, punitive actions toward private sector executives, and generally attempting to morph our capitalistic system into a fascist one, Volcker enunciates a great deal of common sense.

His remarks begin by focusing on potential changes in the regulatory approach to financial services,

"But beneath the seeming consensus on the broad elements of reform, there is a lot of disagreement. There's a lot of disagreement in principle and even more disagreement in detail. So there is a great kind of political pressure to get things done in a hurry, strike while the iron's hot.

I guess my principal feeling is: Not too fast, because any specific reform raises questions about how it fits into the whole system. And unless you have some idea of the direction in which you want the system to go, it's a little premature to be taking too much specific action.

The other way to look at it, which I favor, is no, there are distinctions that legitimately can and should be made, not only on institutional grounds but on historic grounds and given the present framework we have. And the one is a commercial bank-centered approach, accepting that commercial banks are going to be the core of any system. They've been regulated, they're going to continue to be regulated. We can improve that regulation. Those institutions have a fiduciary responsibility to serve the public, to serve their individual clients, to serve business, to serve governments. That's their job, and they also underlie the infrastructure.

The rest of the system I call a capital-market system. I would not consider them at the core of the system. They might be important, they innovate, they're flexible, but the implication is they don't need to be regulated to the extent of the banking system. Transparency is important. If one of those institutions gets so big they're in some sense systemically important, maybe we have to regulate them with capital requirements. Otherwise, I don't think there should be any presumption that the government is going to rescue them."

I find this astonishing and comforting. Volcker is essentially arguing that we retain our focus on banks, and reinforce with investors that non-bank participants in finance bear risk that will not, despite current federal government actions, be rescued. In this, I think Volcker is correct, and, if influential in the current administration, a tremendous force for slow, sensible changes, if necessary, in regulation.

Volcker then comments on this new notion of a 'systemic risk regulator.' His comments include these,

"Everybody wants a systemic-risk regulator. What is that supposed to do? And what do you mean by systemic risk? Are we talking about a regulator that's going to regulate in detail those institutions? They're going to send in examiners? If so, what do the other banking regulators do? Do they follow the same policies, different policies?

Or do we mean by systemic-risk regulator they're looking for overriding trends in the system that will over time be destructive? Should they have been sensitive to the subprime-mortgage problem and the enormous growth in mortgages, not by looking at individual institutions but by looking at what the market as a whole was producing. Should they have been concerned about an undercapitalization of the banking system generally? That's a different approach than looking at individual institutions.

And what is that systemic-risk regulator supposed to do? What is his charge? Let's not invent the role before we know what the charge should be.

Again, I think Volcker is incredibly astute in calling a spade a spade. Having been involved in my share of risk-related matters while research director at Oliver, Wyman & Co., now the financial services consulting unit of Mercer Management Consulting, I can vouch for Volcker's reticence in tackling this issue.

Whenever I hear government officials begin to babble about 'systemic risk,' I immediately want to ask him/her to define, with equations and variables, precisely what they mean.

Of course they could not. I'm quite sure that even risk management practitioners in most of today's commercial banks and asset management firms could not, either. Or at least not in anything approaching a univocal view of the subject.

Volcker correctly notes this, and even some of the potential conceptual definitions. In this, I think he helps put the brakes on any rush to invent this type of risk, and then regulate it. We are very, very far from such a point, and Volcker wisely says so.

The Journal article which contains Volcker's remarks ends with his thoughts on a few related topics,

Fair-value accounting: That's a big subject that I don't think we're going to solve in the midst of all this turmoil, but it needs careful discussion and determination.

You have this enormous issue of compensation. Well, there is a great urge politically to do something. Most of what the political system would produce is probably destructive, yet there is a real problem of how to deal with compensation policies.

So I hope we take our time to have a kind of consensus on what the general framework of the system ought to be, and what makes sense in individual instances to put into that framework."

Overall, I found Volcker's comments surprising, given his association with the current federal government administration. He seems to be the Volcker of old, who slew the inflation dragon in the late 1970s and early 1980s, speaking clearly, even against prevailing political winds.

I'm pleased to see him providing counsel to government at such a perilous time.