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The internationalisation of the Volcker rule

What’s at stake: the Volcker rule has seized the attention of bankers and regulators around the world as it poses the question of the outlook for financial regulation globally. Underpinning the initiative is a crackdown on institutions deemed “too big to fail” – an area regulators admit had not been settled via the international supervisory […]

By: Date: February 16, 2010 Topic: Banking and capital markets

What’s at stake: the Volcker rule has seized the attention of bankers and regulators around the world as it poses the question of the outlook for financial regulation globally. Underpinning the initiative is a crackdown on institutions deemed “too big to fail” – an area regulators admit had not been settled via the international supervisory authorities, such as the Financial Stability Board and the Basel Committee on Banking Supervision, until the US political intervention. But whether it is at Davos or at the recent G8 in Canada, there is a growing sense of distance amongst policy makers in Europe from what is so far the boldest financial reform proposal put forward. No later that yesterday Reuters reported that European Union finance ministers are uniting to oppose President Barack Obama’s proposal to limit banks’ size and risk-taking, saying his plan may run counter to EU policy, according to a draft document.

Coordination versus differentiation

Paul Volcker argues that it is critical that his proposal be adopted and spread internationally but at the same time clumsily admits that he hasn’t lobbied, consulted, or gone out to any leader in the world to advocate for it. Alistair Darling goes further and worries that Obama’s bombshell proposals will shatter the consensus within the G20 nations on banking reform. If the result is to make it more difficult to agree reform with other countries, the costs could be high, argues Martin Wolf. As many countries in mainland Europe like very big banks and thus will not be willing to impose size restrictions on them, these proposals are, in important respects, unworkable, undesirable and irrelevant to the task at hand.

Dani Rodrik, on the other hand, argues that building international consensus is the best way to water down any financial regulation proposal. Although, he agrees that the Volcker proposal seems to violate earlier agreements to cooperate with other nations through the G-20, the Financial Stability Board, and the Basel Committee on banking supervision, he concludes that the practical reality is that international coordination cannot deliver the tough regulations, closely tailored to domestic economic and political requirements, which financial markets badly need.

In search of support

Mervyn King argued in a speech back in October against those who claim that proposals involving breaking up the largest banks are impractical. It is hard to see why. Existing prudential regulation makes distinctions between different types of banking activities when determining capital requirements. What does seem impractical; however, are the current arrangements. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly.

Viral Acharya and Matthew Richardson, both of NYU Stern School of Business, argue that on balance, President Obama’s plans – a fee against systemic risk and scope restrictions – seem to be a step in the right direction from the standpoint of addressing systemic risk, if their implementation is taken to logical conclusions.

Loopholes in the proposed rule

Avinash Persaud argues that the logic of downsizing banks that are “too big to fail” is based on an illusion. A 2006 list of institutions considered “too big to fail” would not have included Northern Rock, Bear Sterns, or even Lehman Brothers. Instead, regulators should aim to make the financial system less sensitive to error in the markets’ estimate of risk. The Institute of International Finance makes a similar point and argues that restricting the size or activities of banks or other financial firms will not provide effective protection against systemic risk, which has been triggered by firms of many different shapes and sizes. Artificial restrictions on size are likely to produce material distortions and unmanageable risk patterns within the system.

Naked Capitalism argues that the Volcker rule misses the shadow banking system. Volcker does admit that there is a wee bit of a problem with “systemically significant non-banks” but he seems not to grasp the essence of the problem: that the reason these firms are “systemically significant” is that they are both crucial to the operation of the global debt markets (making them essential to commerce worldwide) and enmeshed via financial mechanisms (repos) and risk transfer devices (particularly credit default swaps) which means if any one of these key players goes down, it risks bringing the entire system down. Rortybomb has a link to a short presentation by the Cambridge Winter Center that makes this point clearly.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.


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