The Volcker Plan and the Politics of Financial Regulatory Reform

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The recent announcement of what I'll call the "Volcker Plan" for regulating banks was sandwiched between two major political events: the election of a Republican Senator from Massachusetts and the Supreme Court's decision "deregulating" corporate campaign contributions. The timing of the announcement in relation to the election of the Republican (Scott Bowen) is suspicious: it suggests a desire to change the subject and recapture the populist mandate by attacking the hated banks in a more dramatic fashion than by the proposal for a bank tax that I discussed in my last post. The suggestion that Vice President Biden was a major advocate for the Volcker Plan reinforces the suspicion of a political motivation. He has no background in business, finance, or economics, but is of course an experienced politician. The administration's contention that the plan had been in the work for months and it's just an accident that it was announced the day after the Massachusetts election is hard to believe.

The significance of the Supreme Court decision is that the decision increases the political power of the banks by enabling corporate rather than just individual financing of ads advocating for or against particular candidates in elections. Congressmen may be reluctant to invite an avalanche of negative ads paid for by banks by voting for regulatory measures that might substantially reduce the profitability of banking.

The administration's tough approach creates the following political problem. On the one hand, in continuing the policy of the Bush administration, the administration has been enormously supportive of the banks, and this has enabled some of them to reap large profits despite the depression. On the other hand, it has been criticizing the banks as pigs, with increasing stridency. The more the administration ratchets up its attacks on the banks--escalating from verbal abuse ("fat cat" bankers) to draconian regulation--the more it plays the populist card and, conceivably, distracts the public from the health care donnybrook, but also, the more it retards recovery by distracting bankers and, if tough regulations are instituted, weakening the banks financially and thus discouraging them from increasing their lending. If as a result economic recovery slows, the administration will pay a political price, while if bank regulation flops as health care reform is flopping, the administration will be thought unable to govern effectively.

It is difficult for the administration to rebut charges of being soft on banks because of the continuity not only of policy but also of personnel between the Bush and Obama administrations. The principal theorists of Bush's response to the financial crash were Geithner and Bernanke, and they're still in place. (The third member of Obama's economic troika, Lawrence Summers, is not as prominent publicly as either Geithner or Bernanke.) Geithner is identified in the public mind with hated Wall Street. Bernanke is identified with keeping interest rates way down is encouraging bank speculation (and high profits) just as the Fed was doing (with his support) in the early 2000s. The turn to Volcker is politically adroit, especially in the wake of the increasing skepticism of the Obama administration on the part of independent voters.

In retrospect, from a purely political perspective at least, the administration would have been better off with a different Secretary of the Treasury and a different Federal Reserve Chairman. Not that it could have removed Bernanke; but by deciding to reappoint him, the President in effect ratified Bernanke's policies. Appointing Volcker to succeed Bernanke might have been better from a political standpoint. Volcker is at once a commanding and a reassuring figure, and cannot be accused of being too friendly with hated "Wall Street."

Enough about politics. The Volcker plan deserves careful consideration. It's a shame it was not taken seriously by the administration from the start; the loss of a year is serious, maybe calamitous, because the plan cannot be adopted overnight. Its evaluation, detailed design, and execution will take years.

The plan is being described in some quarters as "the return of Glass-Steagall." The Glass-Steagall Act, passed in the 1930s depression and repealed in 1999, provided that no company could be both a commercial bank and an investment bank. J. P. Morgan's bank had been both; the Act forced its division into Morgan Stanley (investment bank) and J. P. Morgan (commercial bank). The Act did much else besides; and barring commercial banks from engaging in investment banking in the conventional sense of underwriting new issues of securities would not have averted the financial collapse of September 2008. Even before the repeal of Glass-Steagall, moreover, its thrust of separating commercial banking from other financial activities had been blunted by statutory amendments and regulatory (or rather deregulatory) initiatives. It is the spirit rather than the letter of Glass-Steagall that Volcker wants to revive.

Volcker's basic idea is to insulate traditional commercial banking services from risky modern financing practices. Traditional commercial banking services consist of providing a place to park a person's money (a deposit account and safe-deposit box), making mortgage and commercial loans, administering the payments system (essentially, the system whereby a check written on one bank causes an increase in the payee's account in another bank), providing standby (back-up) credit, and buying and selling Treasury securities and other ultra-safe securities. Banks are either local or have local branches, so that they can engage in "relationship" lending--lending based on knowledge of the creditworthiness of particular borrowers, especially individuals and small business. (Big business has other methods of financing besides commercial banks, such as the issuance of bonds or commercial paper, or by drawing on retained earnings.)

As Volcker recognizes, commercial banks, although they no longer account for more than about 20 percent of all lending, play an essential role in meeting the credit needs, especially (by virtue of their ability to engage in relationship banking) of individuals and small businesses, and also by virtue of administering the payments system and providing back-up credit to issuers of commercial paper and other big-business borrowers. Furthermore, they play an essential role in the Federal Reserve's management of the money supply and control of interest rates, because the Fed in normal times varies the money supply by buying Treasury securities from commercial banks or selling Treasury securities to them. (In the first type of transaction, the Fed increases the amount of money in bank balances and in the second, it reduces the supply of money by retiring the money that it receives in the sale.) This makes it easy for the Fed to increase the banks' liquidity, and thus the availability of credit, in the event of an economic downturn. But this will not work if the banks are insolvent.

Volcker's idea is that if the commercial banking system as a whole is insulated from threat of insolvency, even a wave of bankruptcies of other lenders will not have disastrous effects on the financial system and hence the larger economy. The commercial banks will be the sturdy spine of the finance system, which (with the aid of the Fed) will step up its lending if other parts of the financial system, such as the "shadow banks" (financial firms that provide close substitutes for conventional bank services), fail. Federal deposit insurance is already a big step in this direction, because it reduces the likelihood of a run on a bank. The fact that bank regulators have very broad discretionary powers over banks and can close a bank down if they think it likely to go broke, without waiting for actual insolvency, are additional safeguards. But if the bank is simultaneously engaged in high-risk financial activities, such as originating mortgage-backed securities or engaging in speculative trading with its own capital, the conventional safeguards won't be effective; the banks may still go broke en masse.

That's the thrust of the Volcker Plan, though the version just embraced by the administration is somewhat more limited. The plan (in the form in which I think Volcker himself envisions it) has a lot to commend it, but it has three big drawbacks, which need to be addressed.

The first is that limiting the services that commercial banks can provide is apt to result in a continued shrinkage of commercial banking relative to other finance, possibly to a point at which commercial banking is no longer a large enough industry to constitute the spine of the financial system.

The second and related point is that the commercial banking industry probably is not large enough to fill the hole created by a collapse of the shadow-banking industry. It was the collapse of Lehman Brothers, which was not a commercial bank, that precipitated the most acute phase of the financial crisis of 2008. So the shadow banks need tighter regulation. Whoever regulates the shadow banks (at present, regulation is divided among the Federal Reserve, because the main shadow banks have either been converted to bank holding companies or acquired by banks, the Securities and Exchange Commission, and the state insurance commissioners), however, is likely to be in continuous dispute with the commercial-banking regulatory authority or authorities. The commercial banks will want the shadow banks reined in as tightly as they (the commercial banks), and the shadow banks will resist.

The third problem is the sheer complexity of the giant multiservice banks and the difficulty of carving them up by removing the parts that do not engage in traditional commercial banking.

A possible fourth problem is that there may be significant economies of scope in the combination of differential financial services with commercial banking. But I emphasize "may be;" I don't think there's good evidence one way or another. This uncertainty is a compelling reason for a very careful, nonpolitical study of the Volcker Plan, rather than a rush to adopt and implement it. The sharply negative reaction of the stock market to the announcement of the plan would ordinarily hold little significance. But now that common stocks are a big part of people's wealth (whether in the form of direct ownership of shares or indirectly through pension plans, college-savings plans, and other investment vehicles), any drop in the stock market reduces people's assets, making them reluctant to spend; and any curtailment of spending slows the pace of economic recovery. There is a social value, therefore, to "reassuring" the stock market that any restructuring of the banking industry will proceed in a deliberate and thoughtful manner (as undoubtedly intended by Volcker), rather than in a spirit of vengeance against "Wall Street."

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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