Skimming through the section, I found nothing particularly interesting, other than Paul Volcker's remarks. Everyone else was either one of many unimpressive, unimaginative executives at a cookie-cutter made global financial institution, or hailed from a damaged one.
But Volcker was much different, as usual.
According to Alan Murray's written piece recounting Volcker's comments, he began,
"Well, you are not going to be very happy with my response. I heard an awful lot of particulars here that I agree with to some degree, but my overall impression is that you have not come anywhere near close enough to responding with necessary vigor or structural changes to the crisis that we have had.
I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?
You want boards of directors to be informed about all of these innovative new products and to understand them, but I do not know what boards of directors you are talking about. I have been on boards of directors, and the chance that they are going to understand these products that you are dishing out, or that you are going to want to explain it to them, quite frankly, is nil.
I mean: Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information. I am getting a bit wound up here."
Volcker waggishly announced that, in his opinion, the finest example of financial innovation in the past 20 years, more mechanical than financial, really, was the ATM.
But Volcker's correct. While extending the availability of consumer credit via cards and somewhat more flexible mortgages has been productive, the more esoteric financial engineering products have created more problems than they probably solved. And certainly not contributed to smooth, healthy economic growth.
To provide more conclusive evidence, Volcker reportedly then confided,
"A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.
I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn't know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.
Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it's a lot of intellectual fun."
The man to whom Volcker refers is almost certainly either Myron Scholes or Robert Merton, both of Long Term Capital Management infamy. It's a very telling tale, knowing this. The sort of comment which those who have always suspected financiers of being careless with the systemic impacts of their risk-related activities find confirming the worst of those suspicions.
" I am not sure that I said innovation in itself is a bad thing. I said that I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.
I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse. That is the main concern that I think we all need to have.
If it is really true that the world economy was on the brink of a great depression that was greatly complicated by financial problems, then we have a rather basic problem that calls for our best thinking, and structural innovation if necessary. I do not want to stop you all from innovating, but do it within a structure that will not put the entire world economy at risk."
I like and agree with Volcker's point that productive, useful innovation is fine. But reckless innovation for the sheer sake of bolstering profit margins, which is actually the genesis of most of the more damaging so-called innovations, is not.
Consider, for example, if, instead of CDOs, financial service firms had created exchanges for trading whole mortgage loans. Instead of being forced to buy packages of loans of varying quality, an investor could diversify risk geographically, or otherwise, himself. Risks would be managed via collateral requirements for the exchange members, so the sort of daisy-chain defaults that so worry investors today would be non-existent.
Further, Volcker implies something I also believe, which is that credit derivatives add no value. Probably because he, too, realizes that they can't remove risk, only transfer it. At a cost.
Volcker then addressed what he feels would work,"First, let us agree that we have a problem with moral hazard. I do not think that there is any perfect answer in dealing with it, but I would suggest that we can approach an answer by recognizing that elements of finance have always been risky and that's certainly true of the commercial-banking system.
I think we need the commercial banking system for more than automatic teller machines. Commercial banks are still at the heart of the system.
In a crisis, everybody runs back to the commercial banks. They, after all, run the payment system. We cannot have this global economy without commercial banks operating an efficient payment system globally as well as nationally. They provide a depository outlet for individuals and businesses, and they are still big credit providers for small and medium-size businesses, but they backstop most of the big borrowers as well. The commercial-paper market is totally dependent on the commercial banking market. They are an essential financial institution that has historically been protected. It has been protected on one side and regulated on the other side.
I think that it is extraneous to that function that they do hedge funds, equity funds and that they trade in commodities and securities, and a lot of other stuff, which is secondary in terms of direct responsibilities for lenders, borrowers, depositors and all the rest.
There is nothing wrong with any of those activities, but let you nonbank people do it and you can provide fluidity in markets and flexibility. If you fail, you're going to fail, and I am not going to help you, and your stockholders are going to be gone, and your creditors will be at risk, and that is the way that it should be.
How can I be so blithe about making that statement? We need a new institutional arrangement which I believe has a lot of support. We need a resolution facility. What can that resolution facility do? If one of you fails and has systemic risk, then it steps in, takes you over and either liquidates or merges you, but it does not save you. That ought to be a kind of iron cross."
This squares with my own, and my friend B's views. B predicted the evolution to these sorts of Glass-Steagal banks, as a few national banks morphed into today's Chase, Citi and BofA. He noted, as has Volcker, but over ten years ago, that such large deposit gatherers and lenders would need to be restricted from risking that capital in trading, underwriting or other investment banking activities.
The solution we need isn't more complex regulation, so much as a reasoned return to a past regulation, and better, permanent severing of the riskier finance activities from the federally-insured, mainstays of deposit-taking and basic consumer and commercial lending.