A version of his rule is contained in Section 619, an amendment to the Restoring American Financial Stability Bill going through the Senate at the moment.
Speaking during a discussion at the London School of Economics with the school’s chairman Howard Davies, Volcker told listeners: “It’s being debated [at the moment]. I think the prospects are pretty good.
“There are a lot of things in the bill that I'm not enamoured by,” he added, “[but] there are some basic elements which deserve support. This Goldman business has removed some doubt!”
Volcker, chairman of President Obama’s Economic Advisory Recovery Board, was referring to fraud charges brought against Goldman Sachs by the Securities and Exchange Commission for failing to disclose to investors that the structuring of a collateralised debt obligation it sold them had been influenced by a hedge fund that was going short of the deal.
“The Republicans oppose everything – that’s good politics,” Volcker noted drily. “But there will not be the blanket opposition we thought… prospects are improving.”
Volcker, a Democrat, was chairman of the Federal Reserve from 1979 to 1987.
He said he did not think reconciling the bills passed by the upper and lower houses of Congress would be difficult: “It’s not going to be a big contest bringing the bills together… before Congress goes home [for the summer recess].”
Time to tackle moral hazard
Volcker, who studied at the LSE in the 1950s – “when I was born”, as Davies joked – said it was governments’ responsibility to let banks know where they stood in the aftermath of the crisis.
“The government response was to pour trillions into the system to protect institutions,” he said. “So what are the implications for the future? It’s a moral hazard. If you do nothing, the expectation becomes [that bailouts will continue] in a bigger crisis. The expectation becomes, ‘Why not takes risks?’”
This is the central problem policymakers are now grappling with, he said. “Can we change that expectation? That’s the effort here.”
Volcker emphasised that protecting retail banking was his priority. “Commercial banks historically have been protected [by the Federal Reserve]. Nobody’s talking about removing their support,” he said.
He argued that the role of commercial banks was more fundamental to the US economy that ever before, saying: “These bank licences are essential… If all the hedge funds dropped dead tomorrow, it’s not going to collapse the economy.”
Big banks can take it
Asked what he had to say to Hans-Werner Sinn, professor of economics and public finance at the University of Munich, who suggested that separating retail banking from proprietary trading would mean the end of the European banking model, Volcker responded: “That’s baloney, if I may say. That’s not really the motivation here. The fact is, we’re looking at the US. As a taxpayer, I don’t want to protect the big American banks.”
Volcker argued that there were only five banks for whom prop trading was big business. “These are big banks,” he said. “They could accommodate [the split]. European banks may have a bigger mix, but that still applies to only a handful”, he said, adding that he wouldn’t be too concerned “if they ended up being smaller”.
Asked to respond to economist Martin Wolf’s criticism that mixing retail and investment banking was not what caused the crisis, Volcker was philosophical: “That’s a fair comment. But suppose we don’t [split them]. Whatever they call themselves, they all act like hedge funds.
“What’s the alternative? We’ll have to regulate them all pretty tough, the way we regulate banks. I don’t want to regulate everyone in the whole world. I want to protect one part of the system; I don’t know how else I could do that.”
“The economy survived without CDOs”
Reacting to a suggestion that the Volcker Rule would make the banking world more fragile, Volcker became animated. “That’s precisely the opposite [of what would happen] by pushing this stuff into the open,” he contended. “A general banking licence is the ideal for Goldman, because they get financing cheap and they can leverage the hell out of it.
“Get [prop trading] out on the open market where they can take risks – they can gamble all they want, and if they fail, they fail…. Goldman Sachs now is basically a trading firm, but they also have a banking licence.”
He heaped scorn on the view that reining in financial innovation would be bad for the US economy, saying: “I lived in a day before credit default swaps were invented, and somehow the economy survived. I lived in a day when the economy survived without CDOs – can you believe that?”
Volcker responded lucidly to an audience question on defining the difference between proprietary trading and market-making activity. “That is a question I get all the time – if you ask a banker, he knows… there are 8,000 banks in the US, and maybe 10 have a hedge fund.
“Does [a trading desk] show a lot of volatility in results? That would suggest it was [engaged in prop trading]. If you’re suspicious enough, you take a look at it. If you sit behind a trader, you know when he’s taking a position in the market and when he’s placing an order for a customer.
“Say there was mixing. The regulator must say: ‘Look, you’re going to get a special capital requirement, because we think you’re engaging in proprietary trading.’”
Finally, he had some words of comfort for the new UK government’s coalition panel on banking reform. “They haven't asked me to chair it!” he joked. “They should take a little time to look at [splitting the banks]”, he concluded.
In perhaps a mark of the esteem in which Volcker is held by economists, seemingly regardless of differences of opinion, the 82-year-old was given a long, rousing ovation as he concluded his thoughts.
Tom Osborn +44 207 779 8361 tosborn@fow.com