“The Volcker rule” has haunted the debate about the financial crisis since the argument began, more like a dimly-remembered promise than a recipe for avoiding another calamity. What was it we were supposed to do?
Former Federal Reserve Board chairman Paul Volcker, now 83, led the effort that in the early 1980s battled spiraling inflation to a standstill. His present-day counterpart, Ben Bernanke, performed as great a public service in the autumn two years ago when he flooded the markets with $600 billion in new reserves, lending freely to banks and other financial institutions against all manner of otherwise illiquid assets, and so averted a second Great Depression.
But neither man has embraced a blueprint for reform that might be expected to produce the sort of predictability that lasted for fifty years after the Glass Steagall Act of 1933 carved the banking industry into two sectors, investment banking and commercial banking, and tightly regulated and insured the latter. The world of financial intermediation has grown much too large, too complicated and too innovation-prone for such neat distinctions to be meaningful, almost everyone agrees.
Thus the Dodd-Frank bill passed into law last summer, and regulators in Basel last week announced more stringent capital ratios for international banks, but neither measure paid more than lip service to the Volcker rule, which may be narrowly defined as requiring that banks enjoying public support – those permitted to borrow in a pinch from the Fed, and to offer federal deposit insurance on relatively modest sums – refrain from speculative activity unrelated to their basic businesses.
Nor did either measure attempt to extend regulatory supervision to the series of enormous behind-the-scenes markets among financial intermediaries (everything from money market mutual funds to pension funds) that have grown up over the last thirty years, known as the shadow banking system, where much of the gravest threat occurred. The housing bubble is the relatively easy part of the crisis to understand; far less well ventilated is the way the shock was greatly amplified in a financial system transformed by thirty years of innovation.
Last week, though, almost two years to the day after the failure of Lehman Brothers precipitated a grave financial crisis, a concrete proposal to implement the spirit of the Volcker rule in a manner apparently unrelated to its usual formulation surfaced at a meeting of the Brookings Panel on Economic Activity in Washington, DC.
The proposal to bring the shadow banking system under the regulatory umbrella drew a swift on-the-record response at the meeting from a Federal Reserve Board governor (Daniel Tarullo), non-committal but carefully reasoned, insuring that the proposal would receive a thorough hearing in the financial intermediation industry in the months ahead.
By chartering a new kind of bank, with narrowly-defined rights (only such banks would be allowed to purchase asset-backed securities) and responsibilities (capital requirements, regular examinations), federal regulators could hope to interpose a new layer of differently-motivated (that is, more cautious) bankers between the originators of securitized loans and the eventual purchasers of them, according to Gary Gorton and Andrew Metrick, both of Yale School of Management.
The activities of these new wholesale banks would be narrowly restricted: they couldn’t take deposits, make loans, engage in proprietary trading, or trade derivatives. They couldn’t be sponsored by commercial banks. They would exist for no purpose other than to create dependably safe collateral to be used in transactions in the shadow- banking system. Instead of buying securitized assets directly, final investors would buy the liabilities of these new banks, whose owners would be judged by the soundness of their practices, and could expect to make modest but dependable profits on the spread.
Thereby regulators would gain some measure of control over an otherwise unsupervised asset class that spawned the worst of the trouble during the near-meltdown in 2008 – the species of short-term private borrowing and lending among financial institutions known as repo (for sales and repurchase agreements), a little-known and not widely understood form of money estimated to add up to as much as $12 trillion in gross value in the US alone.
“Repo and securitization should be regulated because they are new forms of banking, but with the same vulnerability as other forms of private bank-created money [mainly demand deposits],” Gorton and Metrick write in “Regulating the Shadow Banking System.” The idea is to preserve banking and repo, but to eliminate bank runs of the sort that briefly brought global commerce to a halt two years ago by making repo safe for depositors.
“It may seem like a funny time” to contemplate further reform, Metrick told the Brookings Panel, with about 40 economists and policy analysts in attendance, “but it is exactly the right time,” because all the machinery is in place to implement new policies, notably the Financial Stability Oversight Council, which was infused with broad powers under the Dodd-Frank Act.
Fed governor Tarullo, speaking for himself and not for other governors or presidents of the twelve Federal Reserve Banks, nevertheless responded with alacrity. The Gorton-Metrick proposal might not be fully elaborated, he said, but already it had “shape[d] our understanding of the role and risks of the shadow-banking system.” He enumerated a number of potential costs and problems that might be associated with such a scheme, noting that it would require a new financial regulatory approach as well as a restructuring of markets themselves.
But, he concluded, “in the face of very real flaws in the pre-crisis state of these markets … there is a very good case for a policy initiative.”
Those impatient for it can read the Gorton-Metrick paper and Tarullo’s discussion for themselves, as well as some further commentary by Tyler Cowen and Arnold Kling. Among the forty or so economists and policy analysts at the meeting of the Brookings Panel, reaction ranged from blasé dismissal to spontaneous enthusiasm. Those craving greater clarity will have to wait.
But remember that they laughed in 1932 when Senator Carter Glass and Congressman Henry Steagall sat down to play the piano. Theirs was an essentially populist reform, but it produced forty years of financial stability and steady growth. For the Dodd-Frank Act of 2010, dealing with consumer protection was the relatively easy part; the statute wisely leaves systemic reform to the experts, in the form of the Financial Stability Oversight Council, with its considerable powers to implement regulation and recommend legislation. For them, the task is to design some new markets.
Jimmy Stewart might be dead, as Laurence Kotlikoff, of Boston University, maintains in his book of that title (which recommends a different form of narrow banking). And there clearly is no way to return to the simple world of “It’s a Wonderful Life,” the 1946 Frank Capra film that depicts a banking panic as it might have happened if federal deposit insurance hadn’t eliminated that particular fear from everyday life.
But there probably is a way to reinvent George Bailey, the prudent, dutiful, good-hearted banker whom Stewart played in the movie, give him some modern togs, and relocate his bank from Bedford Falls to the canyons of midtown Manhattan, to Shanghai and the City of London. The way to implement the Volcker rule is to forget about insurance and concentrate instead on the provision of sound collateral for the enormous river of private transactions. Until recently banking panics were a thing of the past, a parable for the holiday season. There is no reason they shouldn’t be once again.