Rein in Wall Street with more regulation, urges Paul Volcker, former chairman of the Federal Reserve.
Investment banks should be supervised much like commercial banks, Volcker told the Congressional Joint Economic Committee this week.
Best known for crushing inflation under President Ronald Reagan through a series of interest rate hikes, Volcker told elected officials that now "intervention” in the free markets is justified.
Investors will inevitably look for help from the Fed in the future, so it is time to regulate investment banks the way commercial banks are now tightly controlled, Volcker said.
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Important investment banks should be regulated and supervised "along at least the basic lines appropriate for commercial banks that they closely resemble in key respects,” he said.
Just how they should be regulated is the big question, he noted.
The Fed should be the lead regulator, but it needs important changes, he advised.
Congress should give the Fed a clear authority, with a top administrator with unambiguous responsibility. The Fed also needs "stronger staff resources, adequately compensated.”
In other words, more people and money.
The country’s recent open market system dominated by an investment banks and hedge funds has failed, he said. The heavily regulated financial system, with protected banks as the major players was replaced by a more open market system.
Even large commercial banks became more like investment banks.
"But the investment banks and hedge funds that have come to dominate the trading, if regulated at all, have not been closely supervised with respect to their safety and soundness,” Volcker said.
In the new, heavily engineered system, well-paid, mathematically astute people sliced and diced credits (what most people call loans) to pass out risk to investors best able to handle different danger levels.
The result? Enormous complexity and opaqueness.
The new system seemed to work great in fair financial weather.
"However, I believe there is no escape from the conclusion that, faced with the kind of recurrent strains and pressures typical of free financial markets, the new system has failed the test of maintaining reasonable stability and fluidity,” Volcker stated.
The complexity made assessing risk more difficult for both financial institutions and credit rating agencies, and close examination of fancy financial product and their risks was often lost.
The subprime mortgage debacle is only the leading example, Volcker said, inferring that problems are widespread.
"The underlying problem,” he went on, "is that mathematic modeling imbued with the concept of normal frequency distributions found in physical phenomena.
These models, Volcker said, "cannot easily take account of the human element of markets —the episodes of contagious irrational exuberance or conversely ‘unreasoned despair’ that characterize extreme financial disturbance.”
In other words, the Wall Street wiz kids forgot to plug in fear and greed into their formulas.
Most in Congress and other panel witnesses generally agreed with Volcker — to varying degrees.
But Congress should face the reality of regulators’ limited powers, said Alex Pollack, Resident Fellow at the American Enterprise Institute and former CEO of the Federal Home Loan Bank of Chicago.
There was never a golden age when strong regulation prevented financial disasters, Pollack says.
"No matter how you organize any government activity, as time goes by, you will have to reorganize it,” in an attempt to keep up with market changes, Pollack says.
"The perfect answer does not exist.”
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