Larry Summers is out – having withdrawn his name from the short list of possible successors to Fed Chair Ben Bernanke. Among other impediments, the Volcker Rule torched his candidacy. He was against it, while those eager to ward off another financial meltdown – and to punish bankers -- are for it.
Summers has been sharply criticized by those on the left for having championed financial deregulation in the past, and for having a jaundiced view of newly proposed rules. The reality is that Summers understands financial markets, and appreciates the difficulty – and the risks – of overregulation.
Summers is not the only banking savant who thinks the Volcker Rule – that prohibits most large financial firms for trading for their own account -- could damage our financial industry, and possibly our system. Charles Calomiris, professor at ColumbiaBusinessSchool, questions whether adopting the controversial measure could topple our global financial leadership.
In a recent piece in The American, Mr. Calomiris describes the Volcker Rule as a “major threat to banks’ ability to continue acting as market makers…”, observing that it is almost impossible to distinguish proprietary trading from market making. He’s right. Three years in, and regulators cannot figure out how to write a law that makes that distinction.
In Calomiris’ view, what he calls “global universal banks” (and the rest of the world calls banks too big to fail) are uniquely capable of making markets across the world in financial instruments; there are no other firms large enough to perform that role. He argues that the efficiencies delivered from these behemoths have led to unprecedented liquidity. He further suggests that if U.S. banks don’t play this role, European and Asian banks will step in, operating outside the U.S. The damage to New York, and to the U.S., in his view, would be substantial.
These alarms are not politically correct in a nation still struggling to bounce back from the worst financial crisis of our lifetimes. “Too big to fail” has become a cliché, and also a political football as memories of the financial bailouts enrage both the right and the left. There is no better way for financial types to seek political rehabilitation than to vilify their own industry. Former Barclay’s CEO Bob Diamond wrote an op-ed in The Financial Times this week voicing concerns that our banks are still “too big to fail.” Talk about biting the hand that (over) fed you!
A great many Americans (including President Obama) blame bankers for the horrifying losses of jobs and income that trailed behind the collapse of Lehman five years ago. They are partly correct, but the damaging chain reaction was more complex and possible future safeguards are more problematic than people want to hear. The popular view is that ladling even more regulations on top of our financial institutions will cure all ills. It is not true.
Numerous weak links brought down financial markets – and most remain in place. They include the government’s push to weaken lending standards for home loans, the outsized role in the housing markets of Fannie and Freddie, the vulnerability of money market funds to sudden outflows of cash, the influence of and ineptness of the credit rating agencies, and a securitization process in which the lender had no “skin in the game.” Few of these troublesome issues have been fixed.
Fannie and Freddie actually became more dominant players in the mortgage arena in the years after the crash, accounting for 77 percent of all mortgages in 2012, up from 40 percent before the collapse. The government sponsored enterprises (GSEs) are providing credit to a marketplace that is still extremely risk-averse and are annoying the White House by favoring the safest credits. It won’t be long before advocates of broad home ownership push them to lower credit standards to accommodate less capable borrowers.
Money market funds, with $2.5 trillion in assets, remain vulnerable to sudden outflows of cash. Regulators are trying to solve the problem by dislodging funds from their traditional $1 net asset value, saying a fixed net asset value (NAV) produces an unrealistic sense of security among investors.
They argue that it was when the Reserve Primary Funds “broke the buck” in 2008 that investors ran for the hills, pulling out more nearly half a trillion dollars overnight, and destabilizing the short-term credit markets. That’s akin to suggesting that it’s the flashing “Warning” sign on a crashing airliner that most alarms passengers.
Meanwhile, the credit rating agencies continue in the drivers’ seats. Standard & Poor’s and Moody’s have had to make some cosmetic alterations, but their business model is unchanged. At the end of the day, regulators could not pin down how exactly the agencies misjudged the securities that ultimately foundered, and therefore gave up trying to fix the problem.
An Australian court may have stumbled on the truth, when a judge determined that a “reasonably competent” firm would not have rated an overvalued security triple A, but then admitted that the issue in question was “grotesquely complicated.”
Yes, these issues are “grotesquely complicated,” which is why creating safeguards is not only difficult, but also risky. The unintended consequences of changing our financial regulations can be as harmful as the problems they are meant to solve. Recently, regulators overturned the Dodd-Frank rule that banks retain a portion of most mortgages they write, noting that the requirement that lenders have “skin in the game” would hold back the housing recovery.
In a similar vein, New York Fed chief Bill Dudley declared earlier this year that Dodd-Frank heightened the possibility of a run on money market funds. The law, he said in a speech, “raised the hurdle for the Federal Reserve to exercise its Section 13.3 emergency lending authority and because Congress has explicitly precluded the U.S. Treasury from guaranteeing money market mutual fund assets…this may cause investors to be even more skittish in the future.” In other words, in their zeal to protect taxpayers, authorities may have brought a crisis closer.
Larry Summers understands this reality, and the workings of the financial markets, better than most. In my view, it was his provocative personality, and not his common sense approach to financial regulation, that disqualified him.