Volcker Calls for International Coordination of Financial Regulatory Reform

Fearing regulatory arbitrage, former Federal Reserve Board Chair Paul Volcker told Congress that it is absolutely essential that some part of the coming reform of financial regulation be internationally agreed upon and applied in a globally consistent way. Specifically, he listed accounting standards, capital and liquidity standards, and registration and reporting mandates as areas that demand international consistency. He singled out fair value accounting standards as having been inconsistently applied and contributing to downward spiraling valuations in illiquid markets.

In testimony before the Joint Economic Committee, Mr. Volcker, a top Obama Administration adviser, said that international standards will minimize regulatory arbitrage and combat a tendency by some jurisdictions to seek competitive advantage by tolerating laxity in oversight.

The former Fed Chair also asked Congress to impose capital, leveraging and liquidity requirements on large complex financial institutions that pose systemic risks to the markets. Those institutions should also be subjected to particularly high international standards directed towards maintaining their safety and soundness. Mr. Volcker defined systemic risk as a situation where the functioning of the financial system as a whole could be jeopardized in the event of a sudden and disorderly failure.

To help assure the stability of financial institutions, Mr. Volcker urged Congress to impose strong enforceable restrictions on risk-prone capital market activities conducted by hedge funds and proprietary trading firms. This is part of an emerging view, which was endorsed by the earlier Volcker G-30 report and the European Union High Level Group, that there should be regulation of hedge funds and other vehicles whose activities may pose a systemic risk to the markets even if the funds have no direct links to the public at large.

At the same time, Mr. Volcker said that trading and transaction-oriented financial institutions operating primarily in capital markets could be less intensively regulated, although stronger registration and reporting requirements would be appropriate.

Noting that the crisis revealed a massive failure of risk management, the official called for more disciplined financial management and the sound and effective management of risk. He also criticized highly aggressive compensation practices that encouraged risk taking in the face
of misunderstood and sometimes almost incomprehensible debt instruments. He recommended a complete review and reform of incentive compensation practices and other executive compensation practices.

This dovetails with a growing consensus that compensation was misaligned and promoted risk taking. Recently, European Commissioner for the Internal Market Charlie McCreevy said that perverse incentive compensation schemes led to excessive risk taking at many companies and financial institutions and that policy makers should establish clear guidelines to refocus executive compensation on long-term, firm-wide profitability.