Martin Wolf’s column on Paul Volcker’s plan: Readers’ responses

Martin’s column – “Volcker’s axe is not enough to cut banks to size” – drew many responses. Here is a selection of them:

Robert Johnson:

How does one set up a shadow banking system safety net/stabilizing mechanism? Shin at Princeton, Perry Mehrling, at Columbia Barnard and a few others are delving into this.

The part of the Volcker Rule that I find suprising is the notion that one can credibly keep financial institutions out of the safety net when they are large or heavily intertwined. They keep their prop
trading desk and go outside the net until a crisis occurs and then they are right back in at the trough and no policy maker will let them crash for fear of systemic contagion.

I am being led to a view that the scope of guarantees must be large and the ex ante restrictions on the asset side of the balance sheet, (Composition, activities, diversification limits) is the way to go. Acknowledge the pervasive externalities that financial spillovers to the real economy represent and then use that to justify prior restraint. Widespread guarantees must be accompanied by detection of capital deficiency that is timely. Otherwise the banks scale relative to GDP may make these guarantees unsupportable.

The political economy of passage is another thing entirely.

Mickey D. Levy, chief economist, Bank of America:

Martin, I have two comments on your thoughtful article. First, my read is loan demand has fallen significantly, and is more a factor than banks’ tighter lending standards. In the US, this decline in loan demand reflects the extraordinary reductions in nonfinancial business operating costs, inventories, and capital spending, along with the dramatic rise in corporate bond issuance in place of bank lending. Load demand always lag the economic cycle and declines during economic recoveries (C&I loans are a component of the index of lagging indicators), and in the past have not inhibited prior recoveries. Loan demand eventually will rise, but the lags may be longer this cycle, reflecting ongoing deleveraging. In this context, some regulatory reforms that would accelerate deleveraging need to be implemented over an appropriate period of time in order to avoid continued declines in money multipliers and threaten the economic recoveries.
Second, following banks’ lapses, they have dramatically improved their risk management (and management information systems, etc.) in many critical areas, so as you emphasize in your last paragraph, the best approach is to take the time now to do the detailed work so that we end out with an effective financial regulatory apparatus rather than moving hurriedly into adopting policies that have unintended negative consequences for economic performance.


I disagree with much of this article.

One of the arguments is that many European countries won’t follow. But to understand this one has to consider that Europe and Japan have different relations between government and the banks. Where in the US the financial sector more or less dictates the financial policy in Europe and Japan it is the opposite: banks have long served as implementors of government policies. So in Europe and Japan there was much less need for restrictions to achieve responsible behavior from the banks. The effort to create an European financial market may change that but that is another story.

The claim that Europe is wedded to large banks has its limits. Iceland illustrated that banks can become too big for a country. The UK now has serious doubts whether its financial sector is too big to support. I see the same here in Holland when it comes to ING Direct.

Much of the recent financial crisises center around highly leveraged institutions like LTCM and Lehman Brothers. There has been discussion about some kind of clearance system to force them to keep enough reserves. Forcing banks to keep high reserves for loans to such institutions would have some effect too. But the fact is that for the moment we just have to wait whether and when Obama will anounce measures for this aspect of the problem.

Would it really be possible to draw and police a line between legitimate activities of banks and activities “unrelated to serving their customers”? I would expect bookkeeping rules that make it unattractive for banks to have engage more in such activities than strictly necessary for their core business.

Martin Wolf ends discussing “shadow banking”. But the concept stays shadowy and with that its usefullness. It looks like he gathers under this concept a lot of activities, some of which are benificial, others which are definitely not. This makes it impossible to say anything sensible about it.

Martin’s response:

I don’t want to comment on what has been written in response to my piece, except to say that it is excellent stuff, from many different points of view.

I would note that there is one big divide among the serious analysts.

One group thinks that the key is to define and then carve out a set of institutions and practices that are safe, responsible and economically important. Let us call these the commercial banks. The rest – the shadow banking system of trading, securitisation and all the rest – can then be left to do its thing. It will live and die by the market.

The second group thinks this divide is unworkable. In the end, the government will never let huge parts of the credit system collapse, as we found out in late 2008. So whatever is decided must cover the entire system in an effective manner. This means that any structural solutions must also cover the entire system.

I am of the latter school of thought. My colleague, John Kay, is of the first school of thought.