Paul Volcker’s Disappointing Financial Regulatory Reform Report and the Treasury Department

Recently an organization founded by former Federal Reserve Chairman Paul Volcker, The Volcker Alliance, released a report recommending changes to the U.S. financial regulation, “Reshaping the Financial Regulatory System: Long Delayed, Now Crucial.” As any regular readers of this blog could infer, I agree that a main shortcoming of the Dodd-Frank legislation was not addressing the U.S. balkanized financial regulatory structure. Unfortunately, though, the Volcker Alliance recommendations are, for the most part, flawed and unrealistic. They also constitute a direct attack on the Treasury Department and a not very camouflaged increase in the authority of the Federal Reserve.

With respect to the Treasury Department, the report recommends that while the Secretary should remain the chair of the Financial Stability Oversight Committee (“FSOC”), the Secretary should be stripped of his vote. In addition, the report recommends that the Office of Financial Research be removed from the Treasury Department and become an “independent” agency. Also, the report recommends that the Office of the Comptroller of the Currency (“OCC”) be abolished and its “prudential supervisory functions” be assumed by a new “independent” agency chaired by the vice chairman of the Federal Reserve. This new agency would also assume the existing prudential supervisory functions of the Federal Reserve, the FDIC, and the SEC and CFTC (these latter two agencies would be combined). The Federal Reserve, though, “would maintain a team of highly qualified [bank] examiners” to conduct “backup” exams.

There is no extended discussion for why the Treasury Department needs to be relieved of some of its existing authority. The main reason appears to be that the Treasury’s involvement in regulatory matter “could create the appearance of injecting short-term, politically expedient considerations when long-term, often politically difficult decision-making may be required” (p. 30 of the report). This is an argument I have heard over many years, and it is argued most forcefully by Congressional staffers working for committees with oversight of regulatory agencies.

The truth is that regulatory agencies are not as independent as they would seem. While it is true that they have some insulation from political pressure of an incumbent administration, they are more susceptible to Congressional pressure than agencies whose leadership are clearly part of the Administration’s team. I doubt anyone would want to argue that the chairmen of powerful Congressional committees are, in general, any less motivated by political considerations than the White House and cabinet members. Also, industry lobbyists can find it easier to pressure regulatory agencies that do not benefit from the full cloak of the Executive Branch. (Note: Many lawyers will argue that in the final analysis “independent” regulatory agencies must be part of the Executive Branch and probably subject to Presidential authority, since there is no fourth branch in the Constitution.)

Another problem with the Volcker Alliance argument is that it ignores some historical experience. First, and important to me since I was heavily involved, is Treasury’s role in the regulation of the government securities market. There were problems in the government securities markets in the first half of the 1980s, particularly with respect to repurchase agreements (“repos”). In 1986, the Government Securities Act was passed which gave the Treasury rulemaking authority over government securities brokers and dealers and delegated enforcement of Treasury rules to the primary regulators of these entities, which might be commercial banks or brokers or dealers registered with the SEC. The Act required then unregulated government securities brokers and dealers to register with the SEC.

In the 1986 law, the Congress passed very short deadlines for Treasury to issue regulations. Unlike the case with Dodd-Frank, with a lot of effort and long hours, we met every deadline to the day. Also, the Act served to clean up the problems in the government securities market.

I would note that the initial preference of the financial community and some in Congress was for the Federal Reserve to assume this authority rather than Treasury. I doubt that the Federal Reserve would have been more effective than Treasury, and it may have been more susceptible to the influence of the arguments from banks that certain rules not be as strict.

The report makes no recommendations involving the government securities markets and ignores Treasury’s regulatory role. It reads as if the authors were unaware of it.

With respect to the OCC, the report does not mention that, as a practical matter, the Secretary of the Treasury has little control over the OCC, even if it is technically part of the Treasury Department. For example, unlike the IRS, OCC regulations are not subject to Departmental approval, and the Comptroller’s statements before Congress contain a disclaimer that effectively says that the statement may not reflect the position of the Administration.

I agree with the report that consolidation of the bank regulators would be desirable, and, without studying the details of any particular proposal, I am agnostic about whether the bank regulator should be under the Treasury Department. The OCC has been criticized at times for being too friendly with the banks it supervises and on which it depends for funding.  I am not, though, enamored of increasing the Fed’s regulatory authority over banks, since I am not convinced that the Fed can fully separate its monetary policy responsibilities from its bank regulatory responsibilities. While the prudential regulator the report proposes is supposed to be independent, this does lead one to ask why the Fed’s vice chairman is proposed to be its chair. In such a situation, I would suspect the Fed vice chair would not only be relying on advice from the staff of the new agency but also from other Fed Board members and Fed staff, both at the Board and the Federal Reserve Banks.

Also, just as the report ignores the Treasury’s regulatory role in the government securities markets, it also ignores some other Treasury roles in writing regulations that affect financial institutions. Specifically, the Treasury’s Office of Foreign Assets Control (“OFAC”) writes regulations concerning how financial institutions deal with transactions or attempted financial transactions and assets of countries, organizations, or individuals which are subject to U.S. sanctions of one sort or another. In addition, a Treasury bureau, the Financial Crimes Enforcement Network (“FinCEN”), writes regulations dealing primarily with money laundering. OFAC and FinCEN regulations can be quite burdensome on financial institutions, and Treasury relies on regulatory agencies to assist in making sure the compliance programs of financial institutions are adequate. Because of the burden of these regulations, there can be tension among the regulatees and the financial regulators concerning these rules. The report does not discuss these issues.

Concerning the Fed, the report makes a passing reference to one of its failures in the prelude to the 2008 financial crisis. The report argues that if the FSOC had established a Systemic Issues Committee (“SIC”) as it recommends, then, “the SIC could have reviewed the Federal Reserve’s rule under the Home Ownership and Equity Protection Act and required the Federal Reserve to write more robust rules to stem the flow of poorly underwritten subprime loans” (p. 32). This, however, also serves to underline the Fed’s weakness as a regulator, especially when it is under the control of a politically astute, powerful, and ideological chairman.

The Fed is an amazingly sophisticated political player. It managed to expand its regulatory authority in the aftermath of the financial crisis for which its policies were partly responsible. It also has a reputation of having extremely talented staff.

With respect to the expertise of Fed staff, one should remember that in the years prior to the real estate market collapse, the Fed was arguing that there was no bubble. This was not only the view of Chairman Greenspan but the argument of various articles published by the Federal Reserve Banks. This was an economic mistake of the highest order.

I once heard Alice Rivlin, a former Fed vice chair and a current member of the Volcker Alliance board of directors, excuse this at a conference at the Brookings Institution by saying very few people saw the real estate bubble for what it was. I cannot emphasize strongly enough that it was perfectly obvious that there was a real estate bubble, just as it had been perfectly obvious that there had previously been a bubble in tech stocks. Valuations made no sense. What was not obvious, and it never is with bubbles, is the timing of the inevitable burst. In my observation, bubbles seem to last longer than one would expect; it apparently takes some time to run out of “greater fools.” Also, I would grant that, while it was obvious that there was a real estate bubble, few realized the extent of the financial and economic devastation which occurred when it ended. However, one did not have to be enormously prescient that the real estate bubble would not end well.

During his remarkable career, Paul Volcker has not only been President of the Federal Reserve Bank of New York and chair of the Fed’s Board of Governors, he was an Under Secretary of Treasury during the Nixon Administration during which the Bretton Woods system came to an end. He has apparently concluded, given his experience at both institutions, that the Fed is better one to be trusted with important regulatory responsibilities. I would argue that both institutions have strengths and weaknesses. (I spent most of my career at Treasury, but also worked for a brief period at the Federal Reserve Bank of San Francisco in the late 1970s, and worked closely with Fed staffers on various issues while at Treasury.) Depending on the Administration and in particular the identity of the Secretary, the Treasury Department at times may be overly influenced by short-term political considerations. The Fed, on the other hand, has to manage any perceived conflicts of its monetary policy responsibilities with its regulatory responsibilities. The Fed can also be unduly influenced by a long-serving and powerful chairman. In addition, and this is perhaps less well known, the Fed also has to resolve the differences among the Board and Fed Bank staffs. For example, while I was at Treasury, the Board staff tended to be more free market and academic in its approach to regulation than the staff of the Federal Reserve Bank of New York. The FRBNY, after all, would be on the frontline of cleaning up any mess that would develop. The Treasury’s position on issues where we also had responsibility or an interest was usually somewhere between the Board and Bank views.

There is no perfect solution to reforming the regulatory system, but the Volcker Alliance report is flawed and currently politically impossible. Why then was it issued? I suspect that one of the reasons is that, when there is another effort to reform the financial regulatory system as a result of some problem, the authors hope that someone will pull their report off the shelf and implement at least some of their recommendations. While some of the recommendation may be worthwhile – for example, SEC and CFTC merger is long overdue – the report is disappointing in that it reads as the opening shot of a turf fight between the Fed and the Treasury.