Former Fed Chair Volcker Says Banks Should Be Prohibited from Sponsoring Hedge Funds

Banking organizations should be prohibited from sponsoring and capitalizing hedge funds or private equity funds, said former Fed Chair Paul Volcker, and there should be strict regulation, with strong capital and collateral requirements, on proprietary securities and derivatives trading. In remarks at the Association for Corporate Growth, he noted that extensive participation in the impersonal, transaction-oriented capital market is not an intrinsic part of commercial banking.

In his view, substantial involvement in heavily leveraged finance and heavy proprietary trading almost inevitably entails substantial risk. It also adds a layer of complexity that is challenging for management and poses insidious, unmanageable conflicts of interest with customer relationships in a banking organization. Similarly, Mr. Volcker noted that the travails of AIG amply reflect the implicit and ultimately destructive financial and managerial challenge of combining a core insurance business with risk prone capital market activity.

While acknowledging that hedge funds and other non-banking institutions have played an essential and increasing role in the financial markets, he observed that given the lessons of the recent past the federal oversight and regulation of hedge funds is inevitable and appropriate. The registration of hedge funds and equity funds is a minimal step, he said, and the reporting to authorities of their business models and large positions is appropriate. Collateral requirements and leverage restrictions, with accompanying official oversight, of the largest and systemically significant individual institutions are also needed.

At the same time, the former Fed Chair warned that the presumption of too big to fail must not be extended to hedge funds and other non-banking institutions. Similarly, they should not have access to federal insurance or Federal Reserve financial support. The federal safety net should not be extended beyond the traditional commercial banking community, he averred. Similarly, public money should not be indirectly available to support risk-prone capital market activities and private pools of capital simply because they are housed within a commercial banking organization.

Mr. Volcker endorsed the Administration’s draft legislation establishing expedited official resolution procedures to deal with the potential failures of non-bank financial institutions in an orderly manner, easing a merger or liquidation of non-banking institutions without calling upon public monies.

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