Volcker Examines Fair Value Accounting, Hedge Funds, and Fed's Role

Former Federal Reserve Board Chair Paul Volcker said that the market crisis has raised questions about the usefulness of mark-to-market accounting, particularly its extension in uncertain and illiquid markets to what is euphemistically known as fair value accounting. In recent remarks at the Economic Club of New York, he noted that, while mark-to-market is an essential discipline for hedge funds and other thinly capitalized financial firms, it may not be as suitable for regulated, more highly capitalized intermediaries, such as commercial banks.

Ongoing bank-customer relationships, the value of which is not automatically correlated with reversible swings in market interest rates, cannot be easily reduced to a market price or a mathematical model. He is satisfied that competent independent standard setters are reviewing the highly complex world of fair value accounting with open minds as to the appropriateness of mark-to-market under particular circumstances.

The former chair is also highly concerned about the practice of important commercial and investment banks of moving sponsored and related operations off balance sheet, which he found particularly surprising in light of the well-publicized problems of Enron and other industrial companies. Experience has again demonstrated that off balance sheet cannot be the same as out of mind or out of responsibility, he emphasized, since too much is at risk both financially and reputationally.

Separately, Mr. Volcker said that hedge funds, which managed carefully add to market efficiency, also have the potential for trouble when sponsored by banks. In his view, consideration needs to be given to ways and means of damping excessive leverage, possibly through the influence of the hedge funds’ prime brokers. Similarly, banks in their lending need to resist the dangerous and excessive.

More broadly, the former Fed chair examined the role of the Federal Reserve Board in what many see as its new role of market stability regulator. He observed that US financial regulation is afflicted by fragmented responsibilities, competing and overlapping institutional objectives, and ingrained resistance to change. Established agencies have not been able to keep up with all the complexities. At the same time, the drumbeat of lobbying pressure has not been for more effective regulation, he noted, but, to the contrary, it has been to highlight a fear of allegedly heavy handed and intrusive official intervention damaging to the competitive position of institutions operating in international markets.

The issue now is extending and clarifying the Fed’s oversight duties to investment banks and beyond or, conversely, changing direction toward a new and consolidated regulator. In Mr. Volcker’s view, the Fed’s role should be clarified as a lender of last resort and as a regulator since these functions are inextricably linked to the extent particular institutions are protected by borrowing privileges. The plain implication of recent actions is that in times of stress investment banks deemed of systemic importance are to be so privileged. Since the Fed’s initiative can not be confined to a single aberrant incident, reasoned the former chair, the Board should have direct responsibility for oversight and regulation.

Further, if the Fed is given umbrella oversight of the financial system, internal reorganization will be essential. According to Mr. Volcker, fostering the safety and stability of the financial system would be a heavy responsibility paralleling that of monetary policy itself. Providing direction and continuity will require clear lines of accountability, he added, backed by a stronger, larger, and highly experienced professional staff.