Volcker describes an alternative scenario for regulatory reform

Exclusive analysis forFinReg21 by Darrell Delamaide

“I am not alone in this, and in fact I think that I amprobably going to win in the end.”

It’s the statement of a confident man, and at 82, formerFederal Reserve chairman Paul Volcker, something of a legend in his own time inthe world of finance, is plenty confident.

What he’s talking about is returning to a division ofbanking functions to shield the payment system the world economy depends onfrom high-risk capital markets activities – in short, the separation ofcommercial and investment banking.

He was speaking to senior finance executives gathered inEngland for a “Future of Finance Initiative” organized by The Wall StreetJournal earlier this month.

For Simon Johnson, MIT professor and former chief economistat the IMF, Volcker’s blunt talk at the forum may mark the end of the formerFed chairman being sidelined from the policy discussion.

“Now that Paul Volcker has picked up his hammer, he will notlightly set it aside,” Johnson wrote this week in his blog, Baseline Scenario. “Heknows how to sway the policy community and he knows how to escalate when theydon’t pay attention. Expect him to pound away until he prevails.”

Johnson thinks Volcker’s timing is right – the financialsystem has stabilized and the fat profits and bonuses at the banks are fuelingthe anger of a public still plagued by high unemployment and other effects ofthe recession.

Johnson himself was just selected by the UK magazineProspect as the year’s top intellectual dealing with the financial crisis –ahead of Volcker, current Fed chairman Ben Bernanke, Nobel Prize winner PaulKrugman and a score of other picks.

Johnson has been leading the argument against “overmightybanking,” the magazine said. “His ideas are well grounded in theory, but he hasalso done more than any academic to popularize his case: writing articles, amust-read blog, and appearing tirelessly on television,” Prospect said.

Volcker dismissedout of hand the financial innovations touted by the industry, saying theycontributed nothing of value to productivity or to the economy. He mocked theefforts to enhance governance structures at banks to more closely supervisethese innovations.

“I have been on boards of directors, and the chance thatthey are going to understand these products that you are dishing out, or thatyou are going to want to explain it to them, quite frankly, is nil,” Volckersaid at the forum.

The former Fed chairman, the head of a government advisoryboard that is not called upon to give much advice, said one of the fathers offinancial engineering, a Nobel Prize winner, told him that all the innovative financialengineering contributes nothing to the economy. All it does, Volcker said thisman told him, is move around the rents in the financial system. And, the Nobellaureate adds, “it's a lot of intellectual fun.”

Commercial banks, Volcker went on to say, remain at theheart of the financial system, providing the financial intermediation andpayments systems required by the economy. “They are an essential financialinstitution that has historically been protected,” Volcker said. “It has beenprotected on one side and regulated on the other side”.

That fundamental fact will remain and all the rest isextraneous, he said. Hedge funds, equity funds, trading in commodities andsecurities should be left to “you nonbank people,” he told the group.

“If you fail, you’re going to fail, and I am not going tohelp you, and your stockholders are going to be gone, and your creditors willbe at risk, and that is the way that it should be,” he said.

Johnson noted in his blog that Volcker’s proposal to onceagain separate commercial and investment banking is not only radicallydifferent from current reform proposals but an implicit criticism of them.

“Volcker is basically saying that what the administrationhas proposed and what Congress looks likely to enact in early 2010 isessentially – bunk,” said Johnson, who is also a senior fellow at the PetersonInstitute for International Economics.

Johnson sees some financial innovations as downrightdestructive. “Excess financial intermediation, the result of hyperactivefinancial innovation, destroys value by causing people to make investments withnegative returns,” Johnson and co-author James Kwak wrote in an article lastsummer, referring to the way “innovations” like negative amortization andstated-income loans fueled the housing market.

“We cannot say that innovation is necessarily good simplybecause there is a market for it,” the two wrote. “The fact that there was amarket for new houses does not change the fact that building those houses was aspectacularly destructive waste of money.”

If Volcker and Johnson, Krugman and fellow Nobel laureateJoseph Stiglitz and others keep hammering away at their radical proposal forlimiting risk, it’s possible that in this volatile political environment,Volcker will turn out to be right. He may win in the end.