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While much of the past day’s news has been focused on the Obama Administration’s populist announcement that executive pay, at the companies that accept TARP funding, will be capped at $500,000; some less noticed news with a longer term implication was being made by Paul Volcker who testified in front of the Senate Banking Committee. Volcker is the chair of President Obama’s Economic Recovery Advisory Board and the topic of the hearing was “Modernizing the U.S. Financial Regulatory System.”  The New York Times reported on his testimony here

While Volcker had been invited to testify in his role as chairman of Obama’s Economic Recovery Advisory Board, he is also the chairman of the Trustees of the Group of Thirty an influential body composed of leading financiers, academics and central bank officials from around the world. (Larry Summers, Timothy Geithner and Paul Krugman have all been listed as members in the past year)

While Volcker’s testimony was quite general it referenced the recent report of the Group of Thirty titled “Financial Reform: A Framework for Financial Stability.” The Group of Thirty report does give us a window into the thinking of the people who are likely to create the framework for modernizing the national financial regulatory system after the dust begins to settle on the current crisis.

A couple of quotes from Volcker’s testimony will help give a general sense of where the thinking of this elite group is headed:

the Report calls for “particularly close regulation and supervision, meeting high and common international standards” for institutions deemed systemically critical. It also explicitly calls for restrictions on “proprietary activities that present particularly high risks and serious conflicts of interest” deemed inconsistent with the primary responsibilities of those institutions.

On the practical level this is likely to mean an attempt to broaden and expand the Federal Reserve’s powers to supervise and regulate the whole range of non-banks that are involved in the flow of credit around the world.  

Do we think this should be done by the Federal Reserve?
If not who else would have the power and talent to keep up with the innovation and scope of the world’s financiers?
If it is to be the Federal Reserve, how do we inject the possibility of public input and oversight when the Federal Reserve is controlled by economic “libertarians” as it was during the Greenspan years?

And then:

the Report implicitly assumes that, while regulated banking institutions will be dominant providers of financial services, a variety of capital market institutions will remain active. Organized markets and private pools of capital will be engaging in trading, transformation of credit instruments, and developing derivatives and hedging strategies, and other innovative activities, potentially adding to market efficiency and flexibility.

These institutions do not directly serve the general public and individually are less likely to be of systemic significance. Nonetheless, experience strongly points to the need for greater transparency. Specifically beyond some minimum size, registration of hedge and equity funds, should be required, and if substantial use of borrowed funds takes place, an appropriate regulator should be able to require periodic reporting and appropriate disclosure.  Furthermore, in those exceptional cases when size, leverage, or other characteristics pose potential systemic concerns, the regulator should be able to establish appropriate standards for capital, liquidity and risk management.

This seems like pretty weak tea.  Remember that Timothy Geithner spent much of his time during the past five years as President of the New York Federal Reserve speaking about the need for capital and liquidity standards and the need for banks to put better risk management systems in place. But it all proved futile because of the lack of specific rules and regulations and an enforcement system with the capacity of actually holding the players accountable.  

I’m all for the Obama administration putting salary caps on the TARP recipients, but for the longer term the harder job will be creating a regulatory structure that controls or eliminates the current perverse economic incentives for companies to engage in risky behavior in the pursuit of short term profits. This behavior by everyone from the brokers to the lenders, to the investment bankers to the hedge fund managers will not be eliminated by a public scolding, but rather by creating a regulatory system which rewards long term thinking and punishes short term risk taking. In a system in which risk-taking and "innovation" have been highly rewarded, this will be no small task.

Finally Volcker’s testimony points to the critical role that the issue of financial regulation will play in the April meeting of the G-20 leaders in London. President Obama is expected to attend that meeting and it will be likely that some of the framework for the future regulation of the financial services industry that is to be coordinated internationally will begin to be fleshed out. We need grass roots people watching the details during the lead up to this meeting.

Who will watch the watchers?

Originally posted to bankbane on Thu Feb 05, 2009 at 07:09 AM PST.

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