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Volcker and Bernanke: So Close and Yet So Far

05/22/2010 05:12 am ET | Updated May 25, 2011

In case you were wondering, Paul Volcker is still pressing hard for the Senate (and Congress, at the end of the day) to adopt some version of both "Volcker Rules". It's an uphill struggle - the proposed ban on proprietary trading (i.e., excessive risk-taking by government-backed banks) is holding on by its fingernails in the Dodd bill and the prospective cap on bank size is completely missing. But Mr. Volcker does not give up so easily - expect a firm yet polite diplomatic offensive from his side (although the extent of White House support remains unclear), including some hallmark tough public statements. It's all or nothing now for both Volcker and the rest of us.

But at the same time as the legislative prospects look bleak (although not impossible), we should recognize that Paul Volcker has already won important adherents to his general philosophy on big banks, including - most amazingly of late - Ben Bernanke, at least in part. In a speech Saturday, Bernanke was blunt,

"It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation [like fall 2008]."

You may dismiss this as empty rhetoric, but there is a definite shift in emphasis here for Bernanke - months of pressure from the outside, the clear drop in prestige of the Fed on Capitol Hill, and the pressure from Paul Volcker is definitely having an impact.

Bernanke finally understands the "doom loop" - in fact, he provides a nice succinct summary:

"The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too-big-to-fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks."

He also expands on an important, related point - that the presence of "too big to fail" is simply unfair and really should be opposed by all clear thinking businesspeople who don't run massive banks (aside: someone kindly point this out to the Chamber of Commerce - they are undermining their people),

"Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses.... In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too-big-to-fail problem once and for all."

Bernanke now endorses the first Volcker Rule, "Some proposals have been made to limit the scope and activities of financial institutions, and I think a number of those ideas are worth careful consideration. Certainly, supervisors should be empowered to limit the involvement of firms in inappropriately risky activities."

But he is still hampered by the illusion that there is any evidence we need megabanks in their current form - let alone in their likely, much larger, future form. Let me be blunt here, as the legislative agenda presses itself upon us.

I've discussed this issue - in public where possible and in private when there was no other option - with top finance experts, leading lawyers, preeminent bankers (including from TBTF institutions), and our country's most prominent policymakers. And I have testified on this question before Congress, including to the Joint Economic Committee, the House Financial Services Committee, and - most recently - the Senate Banking Committee, where leading spokesmen for big banks were also present.

Mr. Bernanke, with all due respect: there is simply no evidence to support the assertion that, "our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope," at least if this implies - as it appeared to on Saturday - we need banks at or close to their current size.

We can settle this in a simple and professional manner. Ask your staff to contact me with the evidence - or, if you prefer, simply have a Fed governor provide the compelling facts in a speech and/or have a staff member put out the technical details in a working paper.

There is no compelling case for today's massive banks, yet the downside to having institutions with their current incentives and beliefs is clear and awful. Think hard: what has so far changed for the better in the system that brought us to the brink of global collapse in September 2008? In this context, Mr. Bernanke's three part proposal for dealing with these huge banks should leave us all quite queasy:

  1. He wants tighter regulation. Fine, but what happens next time there is "let it all go free" president again - a Reagan or a Bush? Regulation cannot be the answer; there must be legislation.
  2. Improving the clearing and settlement of derivatives is also fine. But why not also make the banks involved smaller - given that a bankruptcy of a future megabank could easily involve millions of open derivative positions? This would also make complete sense as a complementary measure - unless you think society would lose greatly from the absence of megabanks. Again, show us the evidence.
  3. A resolution authority is not a bad idea. But everyone involved in rescuing the big banks with unconditional guarantees in spring 2009 insists on one point - if they had run any kind of FDIC-type resolution process, this would have been prohibitively expensive to the taxpayer. You simply cannot have this both ways - either resolution/bankruptcy was a real option in early 2009 (as we argued) or it was not (as Mr. Geithner argues), but in that case the resolution authority (and also living wills, by the way) would change precisely nothing.

Mr. Bernanke needs to face some unpleasant realities. Because of the various actions - some unavoidable and some not - it took in saving Too Big To Fail financial institutions during 2008-09, the Federal Reserve is now looked up with grave suspicion by a growing number of people on Capitol Hill.

The cherished independence of the Fed is now called into question - and losing this could end up being a huge consequence of the irresponsible behavior and effective blackmail exercised by megabanks - who still say, implicitly, "bail us all out, personally and generously, or the world economy will suffer".

Mr. Volcker sees all this and wants to move preemptively to cap the size of our largest banks. Mr. Bernanke has one last window in which to follow suit (e.g., lobbying Barney Frank could still be effective). In a month it could be too late - the legislative cards are now being dealt.

Mr. Bernanke is a brilliant academic and, at this stage, a most experienced policymaker. What is holding him back?

Cross-posted from The Baseline Scenario.