The Volcker Rule

A number of my colleagues and myself (at the FRB St Louis) attended a meeting yesterday with Paul Volcker to hear him opine on the so-called Volcker rule. (He spoke later that evening at Washington University; see here). I haven’t followed the debate on financial sector reform very closely, so I learned a few things.

The central “problem” is the too-big-to-fail issue. How do we deal with it? Enter the Volcker rule.

If I understand correctly, the Volcker rule consists of two parts: [1] A rule determining which institutions are in and out of the social safety net; and [2] A rule determining how institutions out of the safety net, yet important to the financial system, are to be treated in the event they become distressed.

In a nutshell, rule [1] says you are in if you act like a traditional deposit-taking bank. If you want to engage in proprietory trading, then fine, but you will not be included in the safety net (e.g., access to the discount window). Rule [2] consists of some sort of “resolution authority” with the mandate to take over any troubled financial firm that threatens the system, and liquidate its assets in a timely manner. These firms will be allowed to fail.

I do not think that Volcker pretends that this is the solution to the TBTF problem or that this rule, in itself, will lead to perpetual stability. He seems to think, however, that it is an important first step. Well, naturally we had a few questions.

I decided to bring up a few points raised by Steve Williamson here on why TBTF does not seem to a problem in Canada. He replied that Canadian banks were more prudent in their lending. I tried Steve’s line that this was likely the product of better regulation; there is no Volcker rule, as far as I know, in Canada. His reply, at least a part of it, was that Canadian banks did not engage in a lot of proprietory trading anyway.

Well, what could I say? I let it lie there. There were, after all, many other things to talk about. I thought it interesting that he brought up the issue possible systemic risk among those firms outside the safety net. Could the resolution authority really be expected to shut down a large “non bank” financial player? He seemed well aware of the shortcomings and delicate issues involved with any regulatory proposals. Some of his interesting (radical?) views can be found here.

He has quite the sense of humour too, I must say. On Goldman Sachs and conflict of interest he said that GS reminded him of an apple (possibly NYC) full of worms. GS is so intertwined in the finanical sector that every trade they make is a conflict of interest.

The best part, however, was when during one of his explanations, a cell phone started ringing softly. He stopped talking and looked around, but soon discovered that the offending piece was his own. So he leans back in his chair and slowly pulls the phone out of his pocket. He opens it, brings it slowly to his ear and with a deadpan delivery barks out: “Let them fail!” …and then immediately hangs up.

I nominate Volcker to head the resolution authority!

Jasper - The Real Deal!

Undercurrent Trader

About David Andolfatto 95 Articles

Affiliation: Simon Fraser University and St. Louis Fed

David Andolfatto is a Vice President in the Research Division of the Federal Reserve Bank of St. Louis. He is also a professor of economics at Simon Fraser University.

Professor Andolfatto earned his Ph.D. in economics from the University of Western Ontario in 1994, M.A. and B.B.A. from Simon Fraser University. He was associate professor at the University of Waterloo before moving to Simon Fraser University in 2000.

His current research is focused on reconciling theories of money and banking. His past research has examined questions relating to the business cycle, contract design, bank-runs, unemployment insurance, monetary policy regimes, endogenous debt constraints, and technology diffusion.

Visit: MacroMania, David Andolfatto's Page

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