Varley versus Volcker

There was an intriguing juxtaposition last week, as the chief executive of Barclays, John Varley, penned an article on banking reform in the Financial Times the day before Paul Volcker, 82 year-old former Federal Reserve chairman and now chair of the US Economic Recovery Advisory Board, made a speech to the Federal Reserve Bank of Chicago International Banking Conference. The contrast between the attitude and tone of the two statements is striking. Varley was mealy-mouthed and defensive of the privileges of banks; Volcker frank and robust, departing in his speech from his prepared text to give full vent to his criticism of banks’ activities and the need to rein them in.

Varley accepts on the behalf of ‘the banking system’ the existence of ‘failings’, but is vague on specifics. He characterises critics of banks as accusing them of ‘irresponsible lending’ while also complaining that they must provide more credit, but since these criticisms are ‘irreconcilable’ he presumably believes them both to be nonsense. Investment banks are not casinos, he says; those that think many of their activities to be ‘gambling’ are the victims of ignorance. In his conclusion he implies that it is the banks, rather than the public or its representatives, that will do ‘what is necessary to restore confidence, to secure economic recovery and to create a more stable and resilient financial system.’

Volcker contradicts this self-serving line. In his view, ‘the prolonged disequilibrium in the world economy, …the borrowing, the high leverage, and the truly unprecedented levels of debt’ were ‘facilitated and extended by innovations in finance’, in particular the ‘complexity and opaqueness’ of securitization. He believes many derivatives were created not for genuine hedging needs but simply to earn large fees for the originating investment banks. Credit default swaps massively exceeded the actually possible defaults they covered and money market funds are pure regulatory arbitrage with the purpose of avoiding costly prudential constraints. Despite so much of this having been revealed by the financial crisis he still sees ‘signs of longing…for pre-crisis patterns, with its rewards of extraordinary profits and compensation from risk-taking.’

Volcker has been reported as saying that ‘the biggest innovation in the industry over the past 20 years had been the ATM cash machine’, and in his Chicago speech he dismissed concerns that appropriate regulation puts at risk a ‘sensitive and efficient financial mechanism’. In this light, when Varley says that ‘banks have a simple role in society’, he may be making a point that has a rather different resonance than he might have intended. Indeed the role of banks is to ‘help customers take appropriate risks’ as Varley claims. But the emphasis has to be on the appropriate. Appropriate for whom? For the borrower, for wider society, or for the banks themselves? Of course they have to be appropriate for all three. Loans for important household purchases and for new business ventures have to be repayable without the loss of homes or livelihoods; the revenue to repay capital and interest must be obtainable without social and environmental erosion and the banks themselves should on average cover their administration costs and loan risk. In this way banks may lend more or less, but more importantly they must lend better. To the extent that insurance against future price and interest fluctuations (the ‘useful’ side of derivatives to which Varley selectively draws attention in his piece) can provide needed certainty for real business ventures in an uncertain world, this should be provided transparently and at a fair price.

Volcker has previously remarked on excessive pay in the banking sector, and in his Chicago text he pointed out how ‘memories may be short when large rewards are at stake’. Varley’s weasel words referring to ‘pay [that] is consistent with the minimum needed to remain competitive’ are clearly designed to defend the status quo. In his world, traders who can successfully ride the waves of finance they themselves create are a source of profit rather than of instability and the destruction of real value.

The central claim of Varley’s thesis is that there is a ‘difficult trade-off between nurturing economic growth and creating a more resilient financial system’, but Volcker clearly makes the case that there is no such trade off when he says

…to the extent that the complexity, the opacity, the ultimate fragility of financial markets has contributed to the depth and the extent of the recession and its aftermath of unemployment and slow recovery, the need for new regulatory approaches is clear.

Mr Volcker makes it clear that public authorities must act to restrict the freedom of the financial sector to wreak profitable havoc. In particular he advocates transparency and consistency in derivative dealing, more general supervision of non-bank institutions and internalisation of their own risks along with preventing own-account speculation by publicly-supported commercial banks. He points out, however, that ‘judgement’ always forms a large element in financial sector supervision and that it is always very difficult for regulators to act pre-emptively against powerful financial interests. Whether this difficulty can be overcome by the sort of structural changes he hopes to see in financial market regulation must be open to question. From Mr Varley’s approach it seems likely that he and his ilk will continue to do their utmost both to limit such regulation and to frustrate its operation if enacted.

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