Sunday, October 23, 2011

Former Fed Chair Volcker Calls On Congress and the Regulators to Complete Financial Market Reforms, Comments on UK Vickers Report

Former Fed Chair Paul Volcker called on Congress and the federal financial regulators to complete reform of the financial system by regulating money market funds that choose to offer bank-like services and redemption of investments at par, adopting international accounting standards, and requiring the rotation of outside auditors of company financial statements in order to achieve true auditor independence. In remarks at a G-30 co-hosted lecture series, the former Fed Chair also urged regulators and policy makers to finalize policies to end “too big to fail’’ by following through on a meaningful Volcker Rule, ensuring that a strong, clear resolution authority is in place for non-banks, and engaging international financial centers to establish consistent resolution policies. In his view, a practical resolution authority, widely agreed internationally, will be the keystone in a stronger international financial system. Mr. Volcker is Chairman of the G-30 Board of Trustees.

Mr. Volcker emphasized that Dodd-Frank’s prohibitions on proprietary trading and strong limits on sponsorship of hedge funds and private equity funds are important steps to deal with risk, conflicts of interest and, potentially, compensation practices as well. The recent trading losses in Europe illustrate the case for restrictions on proprietary trading and limiting participation in sponsoring private pools of capital beyond US institutions.

Commenting on the recent UK Vickers Report, Mr. Volcker said that, while there are differences in the structural approaches in the U.S. and U.K., the two jurisdictions are in fundamental agreement on the key importance of protecting traditional commercial banking from the risks and conflicts of proprietary activity.

Chairman Volcker also recommended that regulators take steps to increase competition among credit rating agencies, and emphasize investor reliance on in-house credit analysis. He also urged the Administration and Congress to commit to an orderly wind down of Fannie and Freddie, replacing the government’s role in residential mortgages with that of private financial institutions.

It is important to address the role of money market mutual funds in the United States, said the Chairman, adding that the time has come to harness money market funds in a manner that recognizes both their structural importance in diverting funds from regulated banks and their destabilizing potential.

By grace of an accounting convention, he noted, money market fund shareholders are permitted to meet requests for withdrawals upon demand at a fixed dollar price so long as the market valuation of fund assets remains within a specified limit around the one dollar par, in the vernacular “the buck.” Started decades ago essentially as regulatory arbitrage, said the former Fed Chair, money market funds today have trillions of dollars heavily invested in short-term commercial paper, bank deposits, and notably recently, European banks.

Free of capital constraints, official reserve requirements, and deposit insurance charges, money market funds are hidden in the shadows of banking markets, said Mr. Volcker, resulting in diverting what amounts to demand deposits from the regulated banking system. While generally conservatively managed, the funds are vulnerable in troubled times to disturbing runs, highlighted in the wake of the Lehman bankruptcy.

If money market funds wish to continue to provide on so large a scale a service that mimics commercial bank demand deposits, said the Chairman, then strong capital requirements, official insurance protection, and stronger official surveillance of investment practices is called for. Simpler and more appropriately, they should be treated as an ordinary mutual fund, with redemption value reflecting day by day market price fluctuations.

In Mr. Volcker’s view, the greatest structural challenge facing the financial system is how to deal with the wide-spread impression that important financial institutions are too large or too interconnected to fail. The expectation that taxpayers will help absorb potential losses can only reassure creditors that risks will be minimized and help induce risk-taking on the assumption that losses will be socialized, with the potential gains all private. Understandably, noted the Chairman, ``the body politic feels aggrieved and wants serious reforms.’’

First, he said, the risk of failure of large, interconnected firms must be reduced, whether by reducing their size, curtailing their interconnections, or limiting their activities. Second, ways and means must be found to manage a prompt and orderly financial resolution process for firms that fail or are on the brink of failure, minimizing the potential impact on markets and the economy without massive official support. Third, key elements in the approach toward failures need to be broadly consistent among the major financial centers in which the failing institutions have critical operations.

In passing the Dodd-Frank Act, he continued, the United States has taken an important step in the needed directions. But a truly convincing approach to deal with the moral hazard posed by official rescue is critically dependent on complementary action by other countries.

With regard to resolution authorities, said the Chairman, success will depend on complementary approaches taken in major financial centers. Essentially, the authorities need to be able to cut through existing and typically laborious national bankruptcy procedures. The need is for new resolution authorities that can maintain necessary services and day-to-day financing while failing organizations are liquidated, merged or sold, whether in their entirety or piece by piece.

Such resolution arrangements are incorporated in Dodd-Frank, observed Mr. Volcker, but there is skepticism as to whether they will be effective in the midst of crises, and whether market participants will continue to presume that governments will again “ride to the rescue”. In his view, that skepticism is likely to remain until the most important of jurisdictions can be brought into reasonable alignment. His sense is that efforts are well underway to clear away some of the technical underbrush and agree on procedures for intervention and exchanging information. An important element in that effort is the concept of requiring institutions to develop “living wills”. The idea here is to have clarity as to parts of their operations that could stand alone or be sold or merged as part of an orderly and rapid resolution process

Finally, the Chairman noted that the UK Independent Commission on Banking, the Vickers Commission, recently proposed a more sweeping structural change for organizations engaged in commercial banking. In essence, within a single organization the range of ordinary banking operations, such as deposit taking, lending, and payments, would be segregated in a retail bank, which would be overseen by its own independent board of directors and ring fenced to greatly reduce relations with the rest of the organization.

Apparently, said Mr. Volcker, the Vickers Report envisions that customers could deal with both parts of the organization, and some limited transactions permitted between them. But as he understands it, the retail bank would be much more closely regulated, with relatively high capital and other stringent requirements. The emphasis is to insulate the bank from failures of the holding company and other affiliates. There seems to be at least a hint that public support may be available in time of crisis, he said, which presumably would be ruled out for other affiliates of the financial institution.

While acknowledging that he has not absorbed all the practical and legal implications of the U.K. proposal, Mr. Volcker said that ``surely problems abound’’ in trying to separate the fortunes of different parts of a single organization. Directors and management of a holding company are assumed to have responsibility to the stockholders for the capital, profits and stability of the whole organization, he reasoned, which does not fit easily with the concept that one subsidiary, namely the retail bank, must have a truly independent board of its own. As an operational matter, some interaction between the retail and investment banks is contemplated in the interest of minimizing costs and facilitating full customer service. The US experiences with fire walls and prohibitions on transactions between a bank and its affiliates have not been entirely reassuring in practice, said the former Fed Chair.

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