Obama-Volcker Proposals Separating Banks and Hedge Funds Gain International Backing

There is a growing international consensus that the recent proposals by President Barack Obama and former Fed Chair Paul Volcker to separate core commercial banking from some higher-risk securities and hedge fund activities in financial conglomerates and to place a moratorium on further consolidation could help to avoid a new financial crisis by resolving some major risks inherent to the current financial system.

In the view of the OECD, the plan envisions that equity culture activities, particularly where structured products are concerned, should not be subsidized by public support. Moreover, separating these from mainstream activities like deposit-taking and lending, as well as some investment banking activities that correspond to customer needs, such as underwriting, market-making, broking and some derivatives services, could bring important benefits for commercial banking.

The Obama-Volcker proposals could also significantly reduce contagion risk, whereby losses from high-risk activities undermine the viability of all activities of a financial conglomerate, eating up its capital. The proposals could also reduce counterparty risk, said the OECD, since any losses from counterpart failure will be borne by the risk-taking financial firms without affecting core commercial banking activities. More broadly, the proposals will help sustainable growth by focusing management attention on the core needs of bank clients without major distractions and disruptions.All that said, continued the OECD, there are many practical issues in implementing the proposals, most notably detail and timing. Similarly, there are also technical and legislative details to be worked out. If legislation requires banks to sell their higher-risk operations, this should be done over an appropriately long period in order to avoid losses from a fire sale.

Alternatively, the OECD favors separation through the erection of firewall structures under which commercial and investment banking activities are separately managed and capitalized, avoiding the issue of fire sales. But the OECD believes that either approach would improve stability in the longer run by eliminating contagion risk.

Calling the proposals relevant and interesting, European Central Bank President Jean-Claude Trichet said that the central bank is examining them with great care. For one thing, they ensure that banking focuses on the real economy. But, he stressed that the proposals must be coordinated globally at the G-20 and Financial Stability Board level to ensure that there are no loopholes in the integrated global financial system.

ECB Member Lorenzo Bini Smaghi praised the Obama-Volcker proposals as a commitment to the reduction of the moral hazard posed by systemically important financial institutions. An important element of the proposal is that any financial institution that obtains federally-insured deposits or has access to refinancing from the Federal Reserve would be prohibited from owning, investing in or sponsoring hedge funds or private equity firms. Essentially, the scheme is designed to separate traditional banking activities from higher-risk, proprietary trading operations. It also proposes imposing limits on large financial institutions regarding their market share of liabilities, as a supplement to the existing caps on the market share of deposits.

While noting that these proposals have still not been detailed in depth, the central banker said that the initiative is heading in the right direction and represents the first step to ensuring the financial system can effectively support the real economy and is not weakened by the most volatile market fluctuations. But in order to completely reform the financial regulatory system, he stressed, it is essential that investment banks, hedge funds and other institutions are also subject to adequate regulation. In particular, regulators must have adequate information on the activities of these institutions in order to be able to evaluate vulnerabilities and possible contagion effects.

Another concern is that there is no regulatory arbitrage as the Volcker rules are implemented. The ECB official expects vast financial resources to be employed in an attempt to influence political decisions and to stand in the way of proposals of this kind. The central banker urged the authorities in major countries to put the interests of investors and taxpayers ahead of the interests of financial institutions.