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Volcker Explains His Bank Reform Rules

Paul Volcker, a former chairman of the Federal Reserve and chairman of the president's Economic Recovery Advisory Board, and the person credited with President Obama's recent "Volcker Rule" preventing banks from proprietary trading and investing in hedge funds and private equity, detailed his thoughts on bank reform on the New York Times' Op-Ed page yesterday.

Paul Volcker, a former chairman of the Federal Reserve and chairman of the president's Economic Recovery Advisory Board, and the person credited with President Obama's recent "Volcker Rule" preventing banks from proprietary trading and investing in hedge funds and private equity, detailed his thoughts on bank reform on the New York Times' Op-Ed page yesterday.He spoke of the "moral hazard" of the efforts of central banks and governments to rescue large failing and potentially failing financial institutions.

The phrase "too big to fail" has entered into our everyday vocabulary. It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks.

He described commercial banks as "integral to a well-functioning private financial system. It is those institutions, after all, that manage and protect the basic payments systems upon which we all depend."

But he notes that Adam Smith more than 200 years ago advocated keeping banks small. "Then an individual failure would not be so destructive for the economy," he writes. However, "that approach does not really seem feasible in today's world, not given the size of businesses, the substantial investment required in technology and the national and international reach required."

When banks own or sponsor hedge funds and private equity funds, and when they conduct proprietary trading, Volcker says, they place bank capital "at risk in the search of speculative profit rather than in response to customer needs." He notes that only four or five U.S. banks do this.

In Volcker's ideal world, no capital markets firm would ever be deemed "too big to fail." "What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital - and as ordinary businesses in a capitalist economy, to fail," he says.

Volker, like many other thought leaders, mentions the need for countries to work together on financial regulation. "What is essential now is that we work with other nations hosting large financial markets to reach a broad consensus on an outline for the needed structural reforms, certainly including those that the president has recently set out," he says. "My clear sense is that relevant international and foreign authorities are prepared to engage in that effort. In the process, significant points of operational detail will need to be resolved, including clarifying the range of trading activity appropriate for commercial banks in support of customer relationships."

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