Volcker Says Regulate Investment Banks Like Commercial Banks in Light of Subprime Crisis
Former Federal Reserve Board Chair Paul Volcker told Congress that the natural corollary of the Fed’s Bear Stearns action is that systemically important investment banks should be regulated along the same basic lines as the commercial banks that they closely resemble. Further, if the Fed is to be given an increased role as a market stability regulator, he called for legislation clearly designating a senior Fed official with direct responsibility for prudential market regulation.
In testimony before the Joint Committee on Economics, the former chair reasoned that, however unique was the Fed’s action in extending the safety net to an investment bank experiencing a devastating run, it is inevitable that the nature of the Fed’s response will be taken into account and be anticipated by officials and market participants alike in similar future circumstances.
Given that, he continued, several issues must be resolved by legislation or otherwise. For example, he asks if regulation should be extended to all investment banks and, if so, what is an accepted definition of an investment bank. The next question is what to do about hedge funds. While few hedge funds could reasonably meet the test of systemic importance, he noted, a few years ago a large heavily engineered hedge fund suddenly came under market pressure and was judged to require assistance by the Fed in the form of moral suasion among its creditors.
More broadly, he said that public policy questions are raised by the Fed’s direct intervention into the financial markets, a departure from its time-honored practice of limiting the direct purchase of securities to government obligations. One questions is whether the Fed’s intervention in a broad range of credit market instruments may imply official support for a particular sector of the market.
Mr. Volcker also emphasized that marker reforms cannot proceed independently without a high degree of cooperation with other leading financial powers, especially the European Union and Japan. In a world of globalized finance, he observed, idiosyncratic national approaches cannot be fully effective and may even be counter-productive. Echoing these sentiments, Senator Charles Schumer, chair of the committee, noted that national regulations can only achieve so much in a global financial market. New regulation will do us no good, he proclaimed, if other countries remain lax in their regulations or their enforcement. He also emphasized that the global financial regulatory system should not be the arithmetical equivalent of the lowest common denominator.
The senator also noted that there are no longer any clear distinctions between commercial banks, investment banks and, for that matter, broker-dealers. As large investment banks have come to act more and more like commercial banks, especially now that they can borrow from the Fed’s discount window , then they need to be supervised more strictly The current market is characterized by a large number of financial institutions surrounded by many smaller institutions, such as hedge funds, with their own specialties, a situation the senator characterized as a handful of ``large financial Jupiter encircled by numerous small asteroids.’’ The regulatory structure has to recognize that change. .
Finally, the chair said it is imperative to regulate the currently unregulated parts of financial markets. For example, credit default swaps are a multi-trillion dollar industry almost completely outside the purview of regulators. He advocates the creation of a clearinghouse for
credit default swaps. He would also consider a unique exchange for these swaps as an even more effective way to bring about greater transparency and limit systemic risk.