PAUL VOLCKER: THE MARKET IS “BROKEN”

This is a superb summary of Paul Volcker’s must read comments at the Federal Reserve bank of Chicago from today.  Highly recommended reading (via the WSJ):

1) Macroprudential regulation — “somehow those words grate on my ears.”

2) Banking — Investment banks became “trading machines instead of investment banks [leading to] encroachment on the territory of commercial banks, and commercial banks encroached on the territory of others in a way that couldn’t easily be managed by the old supervisory system.”

3) Financial system — “The financial system is broken. We can use that term in late 2008, and I think it’s fair to still use the term unfortunately. We know that parts of it are absolutely broken, like the mortgage market which only happens to be the most important part of our capital markets [and has] become a subsidiary of the U.S. government.”

4) Business schools — “We had all our best business schools in the United States pouring out financial engineers, every smart young mathematician and physicist said ‘I don’t want to be a civil engineer, a mechanical engineer. I’m a smart guy, I want to go to Wall Street.’ And then you know all the risks were going to be sliced and diced and [people thought] the market would be resilient and not face any crises. We took care of all that stuff, and I think that was the general philosophy that markets are efficient and self correcting and we don’t have to worry about them too much.

5) Central banks and the Fed — “Central banks became…maybe a little too infatuated with their own skills and authority because they found secrets to price stability…I think its fair to say there was a certain neglect of supervisory responsibilities, certainly not confined to the Federal Reserve, but including the Federal Reserve, I only say that because the Federal Reserve is the most important in my view.”

6) The recession — “It’s so difficult to get out of this recession because of the basic disequilibrium in the real economy.”

7) Council of regulators — “Potentially cumbersome.”

8 ) On judgment — “Let me suggest to you that relying on judgment all the time makes for a very heavy burden whether you are regulating an individual institution or whether you are regulating the whole market or whether you are deciding what might be disturbing or what might not be disturbing. It’s pretty tough and it’s subject to all kinds of political and institutional blockages as well.”

9) On procyclicality — “It’s the hardest thing as a regulator in my opinion…when things are really going well, the economy is going well, the market is not disturbed, but you see developments in an institution or in markets that is potentially destabilizing, doing something about it is extremely difficult. Because the answer of the people in the markets is, ‘what are you talking about? Things are going really well. We know more about banking and finance than you do, get out of my hair, if you don’t get out of my hair I’m going to write my congressman.’”

10) Risk management — “Markets that are prone to excesses in one direction or another are not simply managed under the assumption that we can assume that everybody follows a normal distribution curve. Normal distribution curves — if I would submit to you — do not exist in financial markets. Its not that they are fat tails, they don’t exist. I keep hearing about fat tails, and Jesus, it’s only supposed to occur every 100 years, and it appears every 10 years.”

11) Derivatives — “I’ve heard so many stories about how important” derivatives are but “there doesn’t seem to be much doubt that the creation of derivatives has far exceeded any pressing need for hedging.”

12) Money market funds — “Money market funds have encroached so much on the banking market. They are nothing, in my view, but a regulatory arbitrage. The purpose that they serve in handling payments and short term paper is a commercial banking function” but they don’t hold the capital or face the regulation of banks.

13) The Fed and Dodd-Frank — Volcker said it was a “miracle” that despite all the criticism aimed at the Fed the central bank “came out with enhanced regulatory authorities rather than reduced regulatory authorities.

Source: WSJ

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • F. Beard

    The problem: How to do an inherently dishonest business, fractional reserve banking, “prudently”. We’ve only been trying it for about +300 years with various disasters along the way; why quit now? [sarc off] If capitalists won’t do capitalism ethically, from the ground up, then there are socialists, goldbugs and worse in the wings.

  • http://economicdisconnect.blogspot.com/ GYSC

    Well maybe he went nuts, or thinks we can spend any amount as long as we don’t sell debt, as a soveriegn nation and all that.

  • http://www.pragcap.com TPC

    More likely, he doesn’t understand a theory that he wants to criticize :-)

  • Creative Generations

    Thank you, Pragmatic Capitalism for bringing us this concise packet of information. It is much appreciated by me.

    I found this part particularly resonant:

    8 ) On judgment — “Let me suggest to you that relying on judgment all the time makes for a very heavy burden whether you are regulating an individual institution or whether you are regulating the whole market or whether you are deciding what might be disturbing or what might not be disturbing. It’s pretty tough and it’s subject to all kinds of political and institutional blockages as well.”

    [PS – feedback: I wish I could preview my comments, so I could see if I applied your useful tags properly. Oh well, here goes [clicking 'submit' with one eye closed.]

    Really, thanks again for the info. Keep up the good work.

  • boatman

    “on procyclicality”…….that basically no one can take the beer keg away at 2AM…….does anyone think ben will?…..’course the next party has only just begun……tho it won’t feel like it for a long time this time.

    ******************************************************************************

    SOOOO….everyone seems to want stable growth….everyone happy…chicken in every pot…..capitalism just humming along……street corner hangers all in houses they own…..their many girlfriends n countless kids all in houses they own……all of us here musing about PE ratios and the next start-up to go public…..buying and holding…..portfol full of P&G stuff….some even say forgive the idiots that spent their mcmansion home equity on a pool n a Tahoe even tho they are school teachers….boy, that will sure teach them a lesson.lotta evolving coming out of THAT….that’l teach ‘em to ever do that again.

    WAKE UP….its not happening…..never will….we are HUMAN BEINGS…..the most exploitive animals to ever evolve on this planet(with god’s help if you please)……in 20,000 yrs. we pushed the neandertals out of europe(they ran that place for .5 mil yrs.—and they were BADDD people)) onto one rock in the straits of gibralter where the last one died.

    we “discovered” two continents in the late 16th century that were currently being occupied by our distant relatives and 200 yrs. later there were 40 million of them dead…..the lucayans in the bahamas— the women would grab their kids and walk into the water and all drown when the spainish would come to town.

    but now we got computers and we have changed….really?.

    EBAY was not irrational at 350???? (i’m guessing 350)

    2 bdrm 800 sq. ft. house in s. california for 2 mil was not irrational?

    we are irrational…..its one bubble after the next…..get used to it.

  • 3421138532110

    Too right Boatman.

    I’m off to buy some more rare earth metals……:-)

  • Rob Luk

    Boatman,

    I often ponder this, but I am currently largely in agreement with you. It seems that greed is just a natural product of animal evolution. (Greedy critters more likely to survive).

    And then it comes back to that Ghandi quote:

    “Earth provides enough to satisfy every man’s need, but not every man’s greed”

    And so it seems we will exploit each other into eternity, until we wipe ourselves out…

    (And I would argue that greed is a root cause of financial crises)

  • boatman

    i agree…..sad but true…..someday some idiot gonna push the red button…..religon seems to be even a more blinding sensation than greed.

    i live in a 1000 sq ft house, heat w/wood out of choice,never financed anything,own the last gas powered vehicle i will have to buy, can fix anything but the space shuttle—–i could have a bunch of fancy stuff i’m just happy w/what i have.

    but i do understand human greed and survival and i don’t villify either.

  • mutant_dog

    It has been said, “we are all Keynesians now” – humbug !

    Lord Keynes’s theory on cyclicality and government is never completely observed. Governments will invoke the theory when (deficit) spending to stimulate a laggard economy; but they fail to complete the cyclic adjustment Lord Keynes called for, in that they never build up a surplus in good economic time, as called for by the theory. Were a wise government (if one might postulate such) to completely observe the theory, that would be inherently anti-cyclic, smoothing the (inevitable ?)economic cycle.