Volcker's reforms deserve to succeed

PUBLISHED : Wednesday, 27 January, 2010, 12:00am
UPDATED : Wednesday, 27 January, 2010, 12:00am

For two decades, Paul Volcker was eclipsed by his more famous successor at the US Federal Reserve. Alan Greenspan was worshipped like a financial god before the global economic crisis. But his star has fallen amidst the financial ruins. Meanwhile, Volcker, with his reputation for monetary rectitude, has enjoyed a revival. It is, therefore, hardly surprising that what may be the most significant regulatory overhaul of the US banking system since the 1930s now bears the name of 'the Volcker rule'.

With the towering former Fed chairman standing behind him, US President Barack Obama announced the regulatory crackdown last week. A longtime advocate of tough measures against Wall Street excesses, Volcker finally has his day in the sun. His stance is part of a growing worldwide consensus among finance officials and regulators that big banks and other key financial players need to be reined in. For example, the Basel Committee on Banking Supervision, which sets global standards for national regulators, has set higher capital requirements for banks; and before last week, Obama announced a plan to claw back bailout money from banks over 10 years.

The latest reform spearheaded by the White House has two parts. The first restricts the investment activities of banks. This means barring those with insured deposits - and therefore access to emergency funds from the Federal Reserve - from owning private equity or hedge funds, or investing in them. They will also be banned from so-called proprietary trading, that is, gambling with their own capital. The second part aims to prevent large banks from getting any bigger. A long-standing cap on the national market share of deposits is set at 10 per cent for banks in the US. They now face having their assets, including other liabilities besides deposits, capped.

Since much of the reform package is still vague and will, no doubt, change substantially, it is hard for anyone to gauge, at this stage, its full effects and likely outcome. But what has been outlined makes common sense and deserves a full hearing. Unfortunately, given the state of American politics, the naysayers are already out in force against the Volcker rule. But despite the stranglehold Wall Street and its lobbyists have on congressional members, Obama could afford to take them on because of widespread revulsion against their excesses.

A common objection is that the issues being tackled did not cause the big bank losses. That is true, but it is besides the point. Bad lending practices and loose credit conditions have been the cause of most financial crises, including this one. Short of eliminating irrational exuberance and human nature, they are perennial problems that will not go away. And toxic derivatives like mortgage-backed securities, which did trigger the crisis, are out of fashion.

The most successful generals are not those who fight the last war. What Volcker and Obama now target are potential systemic dangers that large banks pose to the overall US economy. By restricting banks' size and reining in their risk-taking activities, they are reviving, in Volcker's words, the spirit of the Glass-Steagall Act, the Depression-era law that helped maintain the stability of America's banking system over decades. Let us hope the new reform will achieve a similar success, for the sake of the US economy and the world's.