Listening to Paul Volcker

You know how far politics has swung to the right when the most left wing guy in the room is the former chairman of the Federal Reserve. But that's what financial reform has come to.

Paul Volcker was an early backer of Barack Obama. He counseled Obama on one of the best speeches of his campaign, his March 27, 2008 address on financial reform at Cooper Union, and sat in the front row as Obama delivered it. This was the speech where Obama declared that no corner of the financial system should be unregulated. And when Obama clinched the Democratic nomination, Volcker was introduced as a senior advisor.

But when it came time to allocate the jobs, the people with the real power managed to freeze out the grand old man of finance. Volcker, who had been touted as a possible treasury secretary, ended up chairing an advisory panel with little influence, the President's Economic Recovery Advisory Board, and for the most part his phone doesn't ring. The board, appointed last year, did not even have its first meeting until May 20.

Yet Volcker has continued to speak out, and he is worth listening to, even if the White House is ignoring him. In his recent testimony before the House Financial Services Committee, Volcker made it clear that he had serious reservations about the recent administration and Federal Reserve policy of propping up financial institutions deemed "too big to fail." Volcker said that the actions amounted to an unintended and unanticipated extension of the official "safety net," an arrangement designed decades ago to protect the stability of the commercial banking system. The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted. Ultimately, the possibility of further crises -- even greater crises -- will increase.

Volcker explicitly challenged the very centerpiece of the administration's proposed reform program, the idea of focusing on "systemically significant institutions," which presumably would come in for additional supervision, but would be rescued if they got into trouble. Volcker said:

The approach proposed by the Treasury is to designate in advance financial institutions "whose size, leverage, and interconnection could pose a threat to financial stability if it failed." Those institutions, bank or non-bank, connected to a commercial firm or not, would be subject to particularly strict and conservative prudential supervision and regulation. The Federal Reserve would be designated as consolidated supervisor. The precise criteria for designation as "systemically important" have not, so far as I know, been set out. However, the clear implication of such designation, whether officially acknowledged or not, will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be "too big to fail."

Think of the practical difficulties of such designation. Can we really anticipate which institutions will be systemically significant amid the uncertainties in future crises and the complex inter-relationships of markets? Was Long Term Capital Management, a hedge fund, systemically significant in 1998? Was Bear Stearns, but not Lehman? How about General Electric's huge financial affiliate, or the large affiliates of other substantial commercial firms? What about foreign institutions operating in the United States?

And, without using the words, Volcker in effect called for a restoration of the core principles of the Glass-Steagall Act, separating commercial banking from investment banking and proprietary trading. He said:

As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets. Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks.

Volcker made similar remarks in a speech in Los Angeles earlier this month. The point is that there is an entirely orthodox view of how to reform the financial system well to the left of the administration's. Similar criticisms have been made by progressives like Paul Krugman and Nobel Laureate Joseph Stiglitz, as well as relative conservatives such as former World Bank chief economist Simon Johnson. But it doesn't get much more orthodox than Paul Volcker.

As Congress deliberates the details of financial reform, several of the key elements of the Obama program fall short -- the idea that "systemic risk regulation" should just be bucked to the Federal Reserve; that immense financial conglomerates are perfectly fine as long as the Fed is keeping an eye on them -- the same Fed that totally missed the sub-prime disaster and that is owned by its member banks; the acceptance of the premise that customized derivative securities need not be traded on exchanges; the continuing toleration of the business models of behemoth financial conglomerates such as Goldman Sachs, which mix investment banking, hedge-fund speculation, proprietary trading for their own accounts, and commercial banking -- making them walking conflicts of interest.

Last week, there was a revealing skirmish on the House Financial Services Committee. The administration blueprint for reform, issued last June and currently being debated in several Congressional venues, includes a Consumer Financial Protection Agency (CFPA). In the draft sent to Congress, the proposed Agency had the authority to require that in addition to marketing other, more complex and risky retail products, banks and other institutions would be required to offer "plain vanilla" products. For example, a bank that marketed more lucrative and risky adjustable rate mortgages would also have to offer a traditional 30-year fixed rate mortgage. A similar "plain vanilla" requirement has been part of New York State banking law for three decades.

But when the White House endorsed the idea, the banking lobby went berserk. It targeted members of the Financial Services Committee, offering campaign contributions to friendly legislators and threatening to support the opponents of pro-consumer members. On September 22, Chairman Barney Frank sent his colleagues a letter declaring that he would oppose any "plain vanilla" language, adding that in his draft of the bill: "Financial institutions will not be required to offer plain vanilla products and services and CFPA will not have the authority to approve or change business plans."

Testifying the next day, Treasury Secretary Timothy Geithner, never an enthusiast of the proposed consumer agency, said Frank's changes were fine with him. But of course, the whole point of consumer regulation is to require banks to "change business plans" when those plans are built around insane products such as sub-prime loans or usurious credit cards. The bill is not even out of committee and the bankers' lobby is having its way.

If the American financial system needs anything, it needs a lot more plain vanilla -- fewer products of Byzantine complexity that serve no economic need other than the profit of their sponsors, less excessive risk, and more service by financial institutions to the real Main Street economy. We should be paying a lot more attention to plain vanilla type guys like Paul Volcker.

Robert Kuttner is co-editor of
The American Prospect and a senior fellow at Demos. His best-selling book is Obama's Challenge.