Fed Governor Speaks Out For Stronger Rules

By Simon Johnson

A powerful new voice for financial reform emerged this week – Sarah Bloom Raskin, a governor of the Federal Reserve System. In a speech on Tuesday, she laid out a clear and compelling vision for why the financial system should focus on providing old-fashioned but essential intermediation between savers and borrowers in the nonfinancial sector.

Sadly, she also explained that she is a dissenting voice within the Board of Governors on an essential piece of financial reform, the Volcker Rule. Her colleagues, according to Ms. Raskin, supported a proposed rule that is weaker, i.e., more favorable to the banks; she voted against it in October.

At least on this dimension, financial reform is not fully on track.

Two years after the passage of the landmark Dodd-Frank financial reform legislation, you might imagine that the crucial detailed regulations would already be in place.

But, not so, at least with regard to the Volcker Rule, which is intended to limit the ability of big banks to make large “proprietary” bets. (Proprietary trading is jargon for speculation – betting on asset prices going up and down.)

The basic idea of this is simple and completely compelling. Paul A. Volcker, the former chairman of the Federal Reserve System, has stressed that this measure will help us move away from an arrangement in which the people who run big banks get the upside when they are lucky – and the rest of us are stuck with some enormous, awful bill when things go awry.   Senators Jeff Merkley, Democrat of Oregon, and Carl Levin, Democrat of Michigan, fought long and hard to get meaningful provisions into the legislation. But these still need to be turned into regulations that must be followed.

The final Volcker Rule was due out last week but did not appear. The current expectation is that it will appear at some point in August. (The Fed is one of five regulators involved in setting the Volcker Rule; the others are the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Securities and Exchange Commission.)

As Ms. Raskin explained in her speech, “I view proprietary trading as an activity of low or no real economic value that should not be part of any banking model that has an implicit government backstop.”

Our largest financial institutions are bank holding companies, which include both banks and enormous trading operations. These activities are intermingled deliberately by bank management – and typically with the approval of regulators.

In a recent study released by the Federal Reserve Bank of New York, Dafna Avraham, Patricia Selvaggi and James Vickery found that legal and organizational complexity – for example, measured by total number of corporations within a single global financial institution (think Citigroup or JPMorgan Chase) – has increased greatly in recent years.

These structures are intended to benefit from association with federally guaranteed deposits as well as the broader but more nebulous protection that comes from being perceived – by officials and by markets – as too big to fail. A commercial bank gives trading operations huge financing advantages, in part because they have the implied backing of depositors and taxpayers; this is why so many banks have put their enormous derivatives trading operations in their insured banks.

Goldman Sachs this week announced that it will expand its regulated bank as a way to obtain lower-cost financing. The federal insurance on deposits is a great deal for a high-risk trading operation like Goldman’s, lowering its financing costs by perhaps 200 basis points (two percentage points, an enormous amount in today’s markets).

Without government guarantees, creditors to Goldman would want to be compensated for the risks they are taking. As things now stand, Goldman is receiving a large implicit government – and taxpayer – subsidy. The same is true at all the other large banks.

Marc Jarsulic of Better Markets points out that, during the height of the financial crisis, the largest financial institutions in the country received a great deal of emergency financing to support their securities operations. At its peak in September 2008, this financing amounted to around $430 billion (per day).

Like it or not, our “banks” have become securities trading operations. (For more on this and all other dimensions of the Volcker Rule, see Better Markets’ “Everything You Need to Know About the Volcker Rule.”)

Even Sanford I. Weill, former head of Citigroup – and a previous proponent of “financial supermarkets” – now thinks megabanks should be broken up. He told CNBC’s “Squawk Box” on Wednesday:

“What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail.”

What these people are converging on is the view that allowing megabanks with their current scale and scope to speculate makes no sense at all.

Unfortunately, we are all learning that just passing a tough law isn’t enough. Regulators must enforce it. Sadly, it seems that our regulators are likely to implement a Volcker Rule with loopholes that may still allow mega-banks to gamble excessively. On the precise nature of these loopholes, see two very powerful comment letters, from Occupy the S.E.C. and Senators Merkley and Levin.

From the tone and timing of Ms. Raskin’s speech, we can reasonably infer that the loopholes remain a big issue. Ms. Raskin uses the metaphor of guard rails on roads: “I was concerned that the guard rails as crafted could be subject to significant abuse – abuse that would be very hard for even the best supervisors to catch.”

Financial institutions know when they are engaged in proprietary trading, but they can hide it well.

The loss-making JPMorgan Chase trading operation in London was headed by Achilles Macris, a well-known proprietary trader renowned for taking risks.

You do not hire a proprietary trader to run a tame hedging operation; you hire him to gamble. You don’t buy a race car to park it in the garage. And when you race it, you have to be prepared for the inevitable crash.

Jamie Dimon, JPMorgan Chase’s chief executive, by all accounts, knew Mr. Macris and fully understood his skill set. And you pay such a trader for his returns from those gambles.

JPMorgan Chase has still not disclosed the structure of its compensation arrangements in its London office, but the likelihood is that compensation must have been in line with standard proprietary trading compensation.

The best way to prevent proprietary trading – as suggested by Better Markets – would be to tie compensation within the securities subsidiaries of bank holding companies to fees for services and trade-flow commissions. Do not pay traders based on their profit and loss on particular positions, irrespective of whether they or anyone else call that proprietary trading.

This and other meaningful restrictions are not likely to be imposed, at least if Ms. Raskin’s concerns about her colleagues are justified.

More serious problems with global megabanks are heading our way.

This column appeared on Thursday on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

14 thoughts on “Fed Governor Speaks Out For Stronger Rules

  1. But our bankers are the most productive people in the history of the world! Just look at their salaries.

    If we did not let them gamble, defraud, etc. with a government guarantee, their productivity would plummet. Is that what you want, Prof. Johnson? IS THAT WHAT YOU WANT?

  2. There’s a very high likelihood the banks’ managements have no idea of the risks they’re carrying. Their regulators obviously do not. See, e.g.,



    This leaves financial markets in an extremely precarious position: If no one knows their own risk profile with any certainty, why would they want to extend credit via trading lines, loans or guarantees to other financial institutions that also do not understand the risks they’re running. The likelihood of your counterparty imploding — a London whale-type blow-up at a less well-capitalized firm, e.g. — and initiating a default cascade is very high in such a scenario.

    Once this becomes apparent, another freeze-up of financial markets is a virtual certainty. So lending will contract, as happened before when everyone lost faith in their counterparties’ ability to make good even on overnight loans.

    This is an element of systemic risk that is not well understood or appreciated. Good thing the OCC’s on watch, huh? … jk

  3. MS Raskin is a voice in the wilderness, so I don’t expect Fed backing of separating the proprietary trading desk for traditional banking functions, so more of the same outrageous and illegal shenanigans by the zombie banks.

  4. > On the precise nature of these loopholes, see two very powerful comment letters, from Occupy the S.E.C…

    When I read this from Occupy the SEC’s submission on the Volker Rule I could only sigh in frustration:
    The Proposed Rule also evinces a remarkable solicitude for the interests of banking corporations over those of investors, consumers, taxpayers and other human beings. In their Overview of the Proposed Rule, “the Agencies request comment on the potential impacts the proposed approach may have on banking entities and the businesses in which they engage,” but curiously fail to solicit comment on the potential impact on consumers, depositors, or taxpayers. The Administrative Procedure Act requires that, prior to the enactment of a substantive regulation, an agency must give “interested persons” an opportunity to comment.14 The Agencies seem to have lost sight of the fact that “interested persons” could include human beings, and not just banking corporations.

  5. Banking corporations are owned by, employ, and serve, human beings. They’re managed by, and regulated by human beings.

    All such being self-interested, and fallible.

  6. @Paddy – unfortunately, selfish and fallible humans have invested “the corporation” with IMAGINARY superhuman and supernatural power.

    Kinda stupid to invest the security of their short animal lives to SUPER stupid, selfish and fallible “gods of chance”…but when did doing something stupid ever stop anyone from having a good time?

  7. Is eliminating derivatives as a product (except for old fashioned hedging by industry participants, e.g., farmers, buyers of precious metals for industrial production, etc.) also part of the Bloom Raskin proposal? If it isn’t, and given the documented role of derivates per se (separately from their locus within the Betting-Depositary monsters, e.g., GS, Citi, JP Morgan, Deutsche, Barclays, PNC, etc.), isn’t the proposal to reduce banking to its role as intermediator in the real (productive) economy an empty gesture resolving little? Recall LCTM — a stand alone hedge fund that required all hands on deck by Treasury, Fed and the coterie of Big Banks.

  8. Edit to above comment:
    “given the documented role of derivatives per se . . . in precipitating the Crash and the ongoing Re/Depression” . . . .

  9. Simon’s argument is that our monetary system is a joke. A monetary system is born subject to its bookkeeper’s framework of rules. To comprehend a monetary system, one must comprehend the rules of that system’s double-entry bookkeeping. What is made clear by Simon and other writers today is that no person in the financial leadership community understands the seven centuries old bookkeeper’s tradition. There are no commercial bookkeeping languages sold today that follow those rules, so how can we even hope to rein in today’s out of control monetary system?

  10. I always preferred barter to today terrible laws, a flat tax on new items, and you get paid to keep the old stuff running, or preserved forever. Simple as that really. As soon as you commit yourself to Caesar, you open up the door for any fraudster, to do as they please.

  11. Cut and pasted from the Moyers-Hedges conversation:

    “The state is not responding in a rational way to what’s happening. If they really wanted to break the back of the opposition movement, rather than sort of eradicating the 18 encampments, they would’ve gone back and looked at Roosevelt. There would’ve been forgiveness of all student debt, $1 trillion, there would’ve been a massive jobs program targeted at those under the age of 25, and there would’ve been a moratorium on more closures and bank repossessions of homes.

    That would’ve been a rational response. Instead, the state has decided to speak exclusively in the language of force and violence to try and crush this movement while people continue this dissent.”

    Okay, so what was it about the demographics of the population of the USA while Roosevelt was President that allowed the BIG CORRECTION to just get up and running? Grandparents and great-parents – so what happened to the gene pool? Seriously, when it has already been done once before, WTF is going on that is so different now?

    True, Israel wasn’t around to be such a Welfare Queen, but what else changed so that we are completely irrational? Drugs? Over-population? TMI – too much information to BE rational?

    Who ARE these “banksters”????

Comments are closed.