“How Mr. Volcker Would Fix It”

Last month Paul Volcker, former Chairman of the Federal Reserve, presented to the Group of 30, an organization devoted to international economic issues, a speech entitled “Three Years Later: Unfinished Business in Financial Reform.”

The real treasures were found in his to-do list for further reforms. That heavy lifting includes addressing capital requirements (make them tough and enforceable), derivatives(make them more standardized and transparent) and auditors (ensure that they are truly independent by rotating them periodically).

He also spoke of the perils of institutions that are too large or interconnected to be allowed to fail. Calling this the greatest structural challenge facing the financial system, he said we must shrink the risks these companies pose, “whether by reducing their size, curtailing their interconnections or limiting their activities.”

He also discussed with Gretchen Morgenson, the author of the article, the unmentioned problems with money market accounts:

Money market funds held $2.63 trillion as of last Wednesday, and, Mr. Volcker said, many people mistakenly think that these funds are as safe as bank accounts. But the safeguards on bank deposits — strong bank capital requirements and federal deposit insurance, for example — do not exist for most money market funds. There is also little official surveillance of the funds’ investment practices.

I was pleased to see that Fannie Mae and Freddie Mac also received his attention.

THE other area that cries out for change, Mr. Volcker said, is the nation’s mortgage market, now controlled by Fannie Mae and Freddie Mac, the taxpayer-owned mortgage giants.

“We simply should not countenance a residential mortgage market, the largest part of our capital market, dominated by so-called government-sponsored enterprises,” Mr. Volcker said in his speech. “The financial breakdown was in fact triggered by extremely lax, government-tolerated underwriting standards, an important ingredient in the housing bubble.”

While he acknowledges that we cannot eliminate Fannie and Freddie anytime soon, “it is important that planning proceed now on the assumption that government-sponsored enterprises will no longer be a part of the structure of the market,” he said.

TOTPS is not fan of Fannie and Freddie – they played a significant role in inflating the housing bubble with their unaccountable lending and buying practices. (And where is OWS in complaining about the bonuses paid to their CEOs?!) Fannie and Freddie will eventually go away, and the sooner the better. They were unnecessary since inception – Volcker: “You ought to be either public or private; don’t mix up private profit-making opportunities with an institution that is going to be protected by the government but not controlled by it.” – and proved themselves disastrous.

But I digress. Volcker makes solid and vital recommendations that are both simple and enforceable. Of course the devil will be in the details, but he clearly does not feel that Dodd-Frank was sufficient. (Joe Klein describes Dodd-Frank as “the watered-down, overly complicated and difficult-to-enforce” reform package.)

One wonders where Obama, Geithner, et al. will attack next, but they should start with a few large-scale reforms. First, allow the Republicans to repeal Dodd-Frank. It is… well… as Klein described it. (They would never do this for political reasons, but it is a lesson in the dangers of rushing important legislation and on how not to spend political capital.)

Second, return the Glass-Steagall Act which prohibited commercial banks from engaging in the investment business,  and third, repeal the Commodity Futures Modernization Act of 2000 which prohibits the federal government from regulating financial derivatives.

Third, increase capital requirements for banks (so they are not over leveraged) and lower the lending requirements of banks (so they can more easily extend credit). Banks do business by borrowing and lending. Increased capital requirements lower their exposure; lowered lending requirements allows them to lend more. They will not easily be able to securitize those mortgages and sell them to others. The will most likely keep those mortgages and loans on their books where they belong. With the separation of commercial and investment banks and the regulation of derivatives, markets should be calmed over concerns with imprudent lending and risky investments tools. Allow commercial banks the ability to lend as they see fit, not according to a one-size-fits-all policy.

Fourth, privatize Fannie and Freddie. The government will lose money, but they have lost already, and can end the liabilities once and for all. Fifth, consider regulating money market accounts as deposit accounts – strong bank capital requirements in exchange for federal deposit insurance. I’m not convinced it is necessary, but out of deference to Mr. Volcker it should be considered.

Lastly, wait and see where things fall. The market may not respond immediately, and the last thing we need is more legislation rushed through Congress for fear of doing nothing.



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Filed under Domestic Politics, Economics

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