Still too big to fail

Former Fed chair Paul Volcker is reiterating his argument for the need to bifurcate the banking industry: commercial banks that are important to the economy, and risky speculators who are on their own.

From Volcker’s speech Wednesday in Los Angeles, the WSJ emphasized limits on the acceptable activities for the former.

Mr. Volcker, who currently is chairman of the White House's Economic Recovery Advisory Board, suggested banks should be restricted to trading on their client's behalf instead of making bets with their own money through internal units that often act like hedge funds.

"Extensive participation in the impersonal, transaction-oriented capital market does not seem to me an intrinsic part of commercial banking," he said in a speech to the Association for Corporate Growth in Los Angeles.
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Mr. Volcker said banks should be banned from "sponsoring and capitalizing" hedge funds and private-equity firms, which are largely unregulated. He also said "particularly strict supervision, with strong capital and collateral requirements, should be directed toward limiting proprietary securities and derivatives trading."

The Bloomberg account explicitly linked Volcker’s proposed control on activities to the availability of bailouts:

In his speech, Volcker renewed his call for a limit on the activities of banks that are considered “too big to fail,” going beyond what other officials in the Obama administration have advocated.

“I do not think it reasonable that public money -- taxpayer money -- be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial banking organization,” Volcker said.

Since January, Volcker has advocated that regulators should prohibit financial companies whose collapse would pose a risk to the economy -- those considered “too big to fail” -- from engaging in certain types of trading and investing activities.

Presumably there is a third group of banks — smaller commercial banks that (as with most of the bank failures of 1980s and the past 18 months) — that can fail and be acquired through normal market processes.

Libertarians and fiscally conservative Republicans would argue one of the biggest mistakes of the Bush administration was to perpetuate the idea of “too big to fail,” an idea that certainly continued into 2009. If the (eventual) financial reforms don’t fix this ongoing moral hazard problem, the bailouts next time will be even worse.

When it comes to financial regulation, the current administration seems to have a quandary. On the one hand, bankers are rich and greedy capitalists worth bashing at every opportunity. On the other hand, many of those based in NYC are very close financial and political supporters to leading Democrats such as the president's chief of staff and the senior senator from NY.

However, right now the assumption is that the administration (and Congressional majority) are uninterested in financial reform, because they want to leverage the president’s (shrinking) electoral mandate to pass a national healthcare plan and cap-and-trade.

If the problem remains unresolved before the GOP retakes one or both houses of Congress, then it will be both an opportunity and a trap for the GOP. This time, the GOP must prove that they really believe in free markets — rather than act as shills for Wall Street — by carefully limiting (and regulating) those firms “too big to fail,” while marking the less regulated segments a truly “bailout free” zone.