Ex-Fed chief Volcker backs central bank keeping power

Former Federal Reserve chairman Paul Volcker said Thursday he opposes proposals to strip the central bank of its bank-regulating authority.

Volcker, who heads President Obama’s economic advisory panel, told the House Financial Services Committee that removing the Fed’s supervisory authority would be a mistake. The Fed conducts bank examinations and sets capital and liquidity standards.

“The Federal Reserve Board should not become an academic seminar debating in its marble palace various approaches toward monetary policy without the leavening experience of direct contact with, and responsibility for, the world of finance and the institutions through which monetary policy is effected,” Volcker said.

A proposal under consideration by Senate Banking Committee Chairman Christopher Dodd, D-Conn., would create one mega-regulator made up of the four national banking agencies including the Fed.

As part of the proposal, supervisory authority over banks would be transferred from the Fed to the new agency. The Fed, in turn, would be responsible only for monetary policy, such controlling interest rates.

Congress also is considering legislation that would remove the central bank’s consumer-protection authority and place it within a new Consumer Financial Protection Agency.

The effort by Dodd reflects in part populist frustrations with the Fed for bailing out the banks using hundreds of billions in taxpayer dollars.

Efforts to emasculate the Fed were supported by Arthur Levitt, a Clinton-era Securities and Exchange Commission chairman, who cautioned against giving the Fed too much power. He told lawmakers he opposes the Fed overseeing monetary policy and bank “safety and soundness” supervision, arguing there are conflicts in that approach.

“The Fed has too many conflicts to do this job effectively,” Levitt said. “Defending the ‘safety and soundness’ of financial institutions and managing monetary policy creates inevitable and compromising conflicts with the kind of vigilant and independent oversight a systemic risk regulator requires.”

Volcker, who headed the Fed between 1979 and 1987, testified that legislators should prohibit commercial banks from engaging in certain risky activities, particularly because they could become the beneficiaries of tax-dollar infusions.

Commercial banks and their holding companies shouldn’t be permitted to own or invest in hedge funds or buyout shops, he said. He added that commercial banks should also be prohibited from a “heavy volume of proprietary trading, with its inherent risks.”

“I think we have learned enough about the challenges and distractions for management posed by the risks and complexities of highly diversified activities,” Volcker said.

Volcker added that there should be some additional checks and balances when it comes to the oversight of the Fed.

He argued that one Fed board governor should be nominated by the president and confirmed by the Senate as a second vice chairman of the Fed board and that this official would have responsibility for overseeing regulation of systemically significant institutions. The official would also have a staff to help identify problem sectors or institutions, Volcker said.

Lawmakers and Volcker clashed over whether the government should continue to be given the flexibility to use taxpayer dollars to prop up institutions in the case of a financial crisis.

Rep. Spencer Bachus, R-Ala., the committee’s ranking member, argued that taxpayers are tired of paying for Wall Street’s mistakes.

“They see something manifestly and fundamentally wrong with a casino environment in which the high rollers pocket the profits, often measured in millions if not billions, while the taxpayers pay off the losses,” Bachus said.

However, Volcker said that he was opposed to abolishing the Fed’s ability to inject capital into the system in the case of an emergency.

“I am not proposing that the Fed’s emergency powers be abolished,” Volcker said. “I squirm when it is used, we know if it ever got used it would set a precedent and we didn’t want to set the precedent of using it, but now that it’s set, we want to develop attitudes and say it’s extremely extraordinary, but I wouldn’t take it away.”

Lawmakers and Volcker also debated the usefulness of a White House proposal that would set up a mechanism to unwind a large insolvent institution in a way that it does not cause collateral damage to the markets.

Bachus said such a process masks the fact that the government was identifying a group of institutions it considers too-big-to-fail.

“When we designate 20 institutions to be too big to fail, we endorse a situation where people will assume they will be saved and there is a guarantee,” said Bachus. “It enshrines the moral hazard issue.”

Volcker said that Wall Street would have a general idea of what institutions are on the list, but even then it actually could be fluctuating at any time, with some smaller interconnected firms included as well.

“It will be difficult to identify in advance who is systemically important, because you may find smaller institutions that have connections with other institutions that create a clog in the system and should be included,” Volcker said. “However, this dismantling authority will diminish the sense that creditors of big banks will be bailed out.”

Such a resolution mechanism could make payouts but it would require bondholders to lose some of their investments or convert their stakes into equity. The mechanism could also force certain problem institutions into mergers, or take other steps “that would not require taxpayer-funded infusions,” Volcker said.

He also said that the government should give the Fed responsibility to survey the whole financial system and block transactions in a sector when the central bank said it believes there is a dangerously large amount of trades in that area. He added that the government should have the ability at any time to say at any time that a particular institution has become too risky and as a result it needs to cap leverage and have a greater amount of capital on hand.

“Somebody should have raised the question that subprime or credit default swaps raised a threat to the markets,” Volcker said.

Volcker said that Congress should require a study be conducted about the viability of the idea of having a financial transaction tax that would be used to inject capital into systemic financial institutions at a time of instability, as an alternative to taxpayer-funded infusions. However, Volcker expressed some reservations.

“If the fee is low enough not to be disruptive to the markets, it won’t be significant enough to pay for these costs,” he said. “If it is large enough for what is needed, it likely will have a disruptive impact on the markets.”

(c) 2009, MarketWatch.com Inc. Source: McClatchy-Tribune Information Services.