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Article by dailystock_admin    (11-10-08 02:13 AM)

STATEMENT OF PAUL A. VOLCKER
BEFORE THE
JOINT ECONOMIC COMMITTEE
MAY 14, 2008
Mr. Chairman and members of the Joint Economic
Committee:
I appreciate the opportunity to discuss informally
some implications of the systemic risks in the financial
system as revealed in the current crisis. This statement
will simply point out some of the more important and
unresolved issues as I see them. The complications are
evident. There are no quick and facile answers. Your
deliberations can, however, help lay the groundwork for
legislation that will, I believe, be necessary, if not now
in the midst of crisis and an election campaign, then in
2009.
The background for the crisis and for any official
and legislative response is the rather profound change in
the locus and nature of financial intermediation over the
past couple of decades. We have moved from a heavily
regulated and protected commercial bank dominated world to
a more open market system, with individual credits
packaged and repackaged and traded in impersonal markets.
Large commercial banks have themselves taken on important
characteristics of investment banks, but the investment
banks and hedge funds that have come to dominate the
trading, if regulated at all, have not been closely
supervised with respect to their safety and soundness.
The new “system” has, indeed, been heavily
“engineered”, with highly talented, well paid, and
mathematically sophisticated individuals dissecting and
combining credits in a manner designed to diffuse risk and
to encourage an allocation of those risks to those most
able to handle them.
The result in practice has been enormous complexity,
and with the complexity has come an opaqueness. In the
process, close examination of particular credits with
2
respect to risk has too often been lost; the sub-prime
mortgage is only the leading case at point.
The complexity has also made it more difficult to
assess risk for the managers of particular large
institutions, for supervisors and for credit rating
agencies alike. The new system seemed to work effectively
in fair financial weather, with great confidence in its
efficiency and presumed benefits. However, I believe there
is no escape from the conclusion that, faced with the kind
of recurrent strains and pressures typical of free
financial markets, the new system has failed the test of
maintaining reasonable stability and fluidity.
One broad lesson, it seems to me, is the limitations
of financial engineering, involving presumably
sophisticated modeling of past market behavior and
probabilities of default. It’s not simply a matter of
inexperience or technical failures in data selection or
the choice of relevant time periods for analysis. The
underlying problem, I believe, is that mathematic
modeling, imbued with the concept of normal frequency
distributions found in physical phenomena, cannot easily
take account of the human element of markets -- the
episodes of contagious “irrational exuberance” or
conversely “unreasoned despair” that characterize extreme
financial disturbance.
It is recognition of those extreme and unsettling
market disturbances that conceptually has justified
official intervention in free markets. That intervention
has taken the form of regulation and supervision and of
providing an official “safety net” for systemically
important institutions, in the past almost entirely
limited to commercial banks and traditional thrift
institutions.
Faced with the evident threat of a potential
cascading breakdown of an already heavily strained
financial institution, the Federal Reserve, drawing upon
long dormant emergency powers, recently felt it necessary
to extend that safety net, first by providing direct
support for one important investment bank experiencing a
devastating run, and then potentially extending such
3
support to other investment banks that appeared vulnerable
speculative attack.
Whatever claims might be made about the uniqueness of
current circumstances, it seems inevitable that the nature
of the Fed’s response will be taken into account and be
anticipated, by officials and market participants alike,
in similar future circumstances. Hence, the natural
corollary is that systemically important investment
banking institutions should be regulated and supervised
along at least the basic lines appropriate for commercial
banks that they closely resemble in key respects.
Several issues now need to be resolved by legislation
or otherwise.
Just how far should the logic of regulation and
supervision be extended? To all “investment banks” and
what is an accepted definition of an investment bank? What
about to “hedge funds” of which I am told there are some
fifty thousand around the world? Presumably very few of
them could reasonably meet the test of systemic
importance. However, a few years ago, a single large,
widely admired, heavily “engineered“ hedge fund suddenly
came under market pressure and was judged to require
assistance by the Federal Reserve in the form, not of
overt official financial assistance, but of moral suasion
among its creditors.
Recent events raise another significant question for
central banking. Given the strong pressures and the
immobility of the mortgage markets – pressures spreading
well beyond the sub-prime sector -- central banks in the
United States and elsewhere have directly or indirectly
intervened in a large scale in those markets. That
approach departs from time-honored central bank practices
of limiting lending or direct purchases of securities to
government obligations or to strong highly rated
commercial loans. Apart from any consequent risk of loss,
intervention in a broad range of credit market instruments
may imply official support for a particular sector of the
market or of the economy. Questions of appropriate public
policy may in turn be raised, going beyond the usual remit
of central banks, which are typically provided a high
degree of insulation from political pressures.
4
That independence is integral to the central
responsibility of the Federal Reserve (and other central
banks) for the conduct of monetary policy.
The Federal Reserve also has in practice, and
enshrined in is founding mandate, certain responsibilities
for commercial banking supervision. In practice, it has in
my mind been properly considered as “primus inter pares”
among the various financial regulators.
In my view, a continuing strong role in banking
regulation and supervision by the Fed has been important
for at least three reasons. First, as the “lender of last
resort” and the ultimate provider of financial liquidity,
if should be intimately aware of conditions in the banking
system generally and of particular institutions within it,
a precondition for decisions with respect to financial or
other assistance.
Second, the widely understood and accepted
independence of the central bank provides strong
protection from the narrow political pressures that may be
brought to bear in the exercise of regulatory
responsibilities.
Third, the broad responsibilities of the Federal
Reserve to encourage orderly growth seem to me to
encourage an even-handedness over time in its approach
toward regulation.
I have long thought the Federal Reserve lead role in
banking (and financial) supervision should be recognized
more clearly than in present law. Experience over time,
reinforced by recent events, also strongly suggests that
if that Federal Reserve role is to be maintained and
strengthened, important changes will be necessary in its
internal organization. Specifically, direct and clear
administrative responsibility should lie with a senior
official, designated by law. Stronger staff resources,
adequately compensated, will be necessary.
I recognize that, if supervisory and regulatory
responsibilities are to extend well beyond the world of
commercial banking and its holding companies, then a more
fundamental question will need to be faced. Should such a
5
large responsibility be vested in a single organization,
and should that organization reasonably be in the Federal
Reserve without risking dilution of its independence and
central bank monetary responsibilities?
Clearly, other large questions are exposed by the
present financial crisis. The role and organization of
credit rating agencies, the use and mis-use of mark-tomarket
and “fair value” accounting, the oversight of hedge
funds, and somewhat removed but nonetheless important, the
growing role of sovereign wealth funds, all need
consideration.
More generally, I must emphasize that little of the
needed changes and reforms can proceed independently,
without consideration of, and a high degree of cooperation
with, other leading financial powers, especially the
European Union and Japan. In a world of globalized
finance, recent experience demonstrates we are all in this
together. Idiosyncratic national approaches simply cannot
be fully effective, and can easily be counter-productive
of needed discipline.
Recent years have brought encouraging progress in a
number of important areas: bank capital requirements,
common accounting standards, growing consistency in
auditing and settlement procedures and elsewhere. It is
those areas of intergovernmental, private, and public –
private initiative upon which we need to build. The
critical pressures on our financial markets are not
unique, nor can an approach to dealing with those
pressures be successful in isolation. We have a lot upon
which to build, and we should not miss the opportunity to
extend the areas of cooperation.

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