The Gold Standard  

On the flight back from Zurich to Singapore, I caught up with Paul Volcker’s statement to the Banking Services Committee of the U.S. Congress (House of Representatives).  The full statement is here. He raises some uncomfortable questions:

However well justified in terms of dealing with the extreme threats to the financial system in the midst of crisis, the emergency actions of the Federal Reserve, the Treasury, and ultimately the Congress to protect the viability of particular institutions – their bond holders and to some extent even their stockholders – have inevitably left an indelible mark on attitudes and behavior patterns of market participants.

Will not the pattern of protection for the largest banks and their holding companies tend to encourage greater risk-taking, including active participation in volatile capital markets, especially when compensation practices so greatly reward short-term success?

Are community or regional banks to be deemed “too small to save”, raising questions of competitive viability?

Does not the extension of support to non-banks, and even to affiliates of commercial firms, undercut the banking/commerce divide, ultimately weakening the commercial banking system?

Will not investors in money market mutual funds find reassurance in the fact that when push came to shove, the Treasury with an extreme interpretation of its authority, took action to preserve those funds ability to meet their declared commitment to pay their investors at par upon demand?

His comments on commercial banks undertaking risk y activities while enjoying Federal Safety Net are spot-on:

As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets.

The point is not only the substantial risks inherent in capital market activities. There are deep-seated, almost unmanageable, conflicts of interest with normal banking relationships – individuals, businesses, investment management clients seeking credit, underwriting and unbiased advisory services. I also think we have learned enough about the challenges and distractions for management posed by the risks and complexities of highly diversified activities.

I do not know if Mr. Volcker would have approved of this letter but I am sure he would have relished reading it as I did.

I do support his support to  the Administration’s proposal to vest all regulatory powers within Federal Reserve, the institution, even if some market participants have legitimate doubts about the philosophical leanings of certain individuals who have led the institution and are still at the helm.

The reason is that  I do believe that regulators’ information on the state of the banking system should inform monetary policy and vice-versa. It is more efficiently feasible only if both responsibilities reside in one agency.

But, both functions should be assigned equal seriousness in terms of calibre, staffing, scope of mandate and autonomy of mandate. Further, both monetary policy-makers and regulators should be asked to specifically spell out (if not to the public) as to how they exploited the synergies of information they come across and diagnosis that they arrived at.

This framework would only enhance the credibility of both the regulatory process and monetary policy-making process. Suffice to say that the Federal Reserve is not there yet but that is no reason to propose a solution that does not address but compounds the problem. So, the great central banker is right on this one.