Perhaps there is redemption after a Fed chairmanship after all.
There have been three chairmen of the Federal Reserve Board of Governors in my adult life. In the month of my 20th birthday, Paul Volcker was appointed, just in time to try to guide us through the most inflationary recession in recent economic history. His name became a household word as people wondered why the most potent economist on the planet could not bring our economy back to normal more quickly and less painfully.
Alan Greenspan followed Volcker’s tumultuous and challenging years. Greenspan rose to the position on the wave of Reagan deregulation. An ardent Ayn Rand devotee, Greenspan believed that almost all markets, and especially financial markets, benefit most when they are regulated the least. Like many ideologues, he saw little value in nuance, and preferred broad and sweeping conclusions to the usual “on the one hand, on the other hand” approach of more highly trained economists.
Greenspan’s philosophy was embraced by Bush I, and then Clinton. In fact, the Clinton administration was far more zealous in its financial market deregulation than Reagan had been. Greenspan, and his ideological brother, Larry Summers, orchestrated the passing of provisions that ensured the burgeoning financial derivatives industry would remain essentially out of the reach of regulation.
When Greenspan’s philosophy led to the Credit Default Swap meltdown, the freefall of AIG into the federal government’s nicely padded safety net, the freezing of global financial markets, and the worst recession since the Great Depression, he left one stinking mess in the lap of Ben Bernanke. Poor Ben. He definitely did not see that coming. And, Alan Greenspan almost apologized when he admitted that his unqualified faith in unfettered markets may have been a bit misplaced.
Things have come full circle. The first of this trio, Paul Volcker, was asked to come up with some regulations that would prevent a financial meltdown from occurring again.
In doing so, he proposed regulations where they have never run before, and undid some deregulation that was the hallmark of the Clinton era Financial Services Modernization Act (FSMA).
Volcker’s rules repealed part of the 1999 FSMA, a law originally motivated by Citibank’s desire to merge with Traveler’s Insurance Group to form Citigroup, that lowered the firewall between the operations of a commercial bank, investment bank or insurance company under one company structure. It enabled investment banks to have access to client capital to invest on its behalf rather than their behalf.
It also removed the conflict of interest barriers for their executives. There is no doubt that an old-school banker feels responsible to depositors and shareholders both. Banking before the FSMA was about steadiness and reliability. After the FSMA and Commodity Futures Modernization Act, executives of banks too-big-to-fail were fascinated, flummoxed and intoxicated by high finance, with its attendant profits and risk. We all witnessed the result.
The Volcker provisions of the emerging Dodd-Frank Act regulations partially puts that genie back in the bottle. No longer can a bank use clients’ capital to invest on its own behalf. Their investment operation can use shareholder capital to invest and earn for their shareholders, but they can’t co-mingle client capital for their own purposes, as they have done.
Another provision will require banks to engage in hedging only to reduce risk exposure. Since deregulation, some banks too-big-to-fail have used derivatives to earn speculative profits rather than reduce risk. Legitimate hedging is like insuring your house up to your potential loss. If you are also insuring your neighbor’s house, you are speculating it will burn down. Speculative hedging that a market could melt down could lead some unscrupulous investment banks to assist in its demise.
While executives will not be held responsible for their banks’ outcomes, they will be required to verify there are responsible processes in place. This is a relaxation from the endorsements post-Enron CEOs must provide as to the accuracy of statements in annual reports.
We’ll see. A handful of regulators are outgunned against a league of the smartest lawyers on Wall Street playing an endless and high stakes cat-and-mouse game where erstwhile regulators make a tenth or a hundredth of the transgressors. Meanwhile, community banks continue to bank.
Colin Read chairs the finance and economics faculty at SUNY Plattsburgh and has published a dozen books on global finance and economics.