Paul Volcker: Financial Regulatory Reform and the Civil Service

In reaction to my comments on the Volcker Alliance recommendations on financial regulatory reform and the Treasury Department, a correspondent writes me to suggest that Volcker may have given up on his efforts of many years to improve the functioning of the civil service by limiting the number of political appointees and strengthening career senior government executives. In my correspondent’s view, Volcker may be recommending that Treasury play less of a role in financial regulation and the “independent” financial regulatory agencies, especially the Federal Reserve, because he has recognized that the civil service has not been reformed. Also, despite his famous frugality, Volcker appreciates that financial regulatory agencies can pay salaries higher than the regular civil service pay schedule, which is important for both recruitment and retention of staff. Most Treasury employees are paid according to the regular civil service pay schedule, with the notable exceptions of the staffs of the Office of Financial Research, which was created by the Dodd-Frank legislation, and of the Office of the Comptroller of the Currency.  

I think my correspondent is on to something. I do not think that the lack of civil service reform is the only reason for the recommendations of diminishing the role of the Treasury Department, but I think it is part of it. The other reason is that I think Volcker, as well as many others, admire the Federal Reserve as an institution and admire its staff. In fact, the Federal Reserve does have good staff, but, as I have indicated in previous posts, the Fed is not infallible and has its weaknesses, as do all government agencies (and all organizations, public or private).

As far as the civil service is concerned, Paul Volcker is right that it should be reformed and the proliferation of political appointees should be stopped and, even, reversed. Clearly, the President has the right to have his own team in place to formulate policies. However, there also needs to be a recognition that many activities of the federal government (for example, managing the public debt) continue from administration to administration and there is a benefit to having senior career people manage many programs and available to give operational and policy advice on request. The knowledge and experience gained from years of government service is invaluable to continuity and in assisting political appointees carry out their specific policy agendas.

Unfortunately, during my tenure at Treasury (and I am told since the end of World War II), the trend is for each incoming administration to name more political appointees and to place them further and further down in the bureaucracy. In my experience, some of these political appointees are excellent; some are mediocre; and some are outright terrible. I often tell people that the hardest part of my job at Treasury was not the substance of what I was working on but figuring out how to relate to each new boss who appeared on average about every two years.

This state of affairs is in general terrible for morale. Younger employees see the situation and come to the conclusion that after a reasonable period of government service they should probably look elsewhere for career advancement. Consequently, the government loses many of its best people.

Moreover, political appointees are not usually motivated to improve the organization they are working for temporarily; they are usually there to advance a particular agenda and to further their personal career goals – some view it as getting their “ticket punched.”  If political appointees go too far down in an organization – and they do at the Departmental Offices of the U.S. Treasury – then no one with responsibility for multiple offices is motivated in improving the organizations’ effectiveness. For example, there is no political appointee is likely to consider implementing programs for career Treasury employees encouraging them to work in multiple areas, including domestic and international, in order to develop senior officials with broad experience in different aspects of the Treasury’s responsibilities. Finally, a problem with having too many political appointees is that it may be more likely that some of them will do considerable damage that outlasts their tenure to the organization.   

As far as pay is concerned, the George H.W. Bush Administration in the wake of the savings and loan disaster decided that new legislation should enable the bank regulators to pay higher than normal government salaries in order to recruit good staff. After some years, legislation extending this pay preference to the SEC and the CFTC was enacted. While the motivation for this is understandable, the government pay issue should be one that is addressed globally, rather than piecemeal. Given the diverse functions and vast size of the government, it is a questionable system for most civil service employees to be paid according to the same rigid schedule overseen by a single government agency (OPM). A way should be devised to give more agencies more flexibility in determining how much they pay employees. (I know that that pay was an issue at Treasury, because when I was recruiting people I could offer them interesting work but could not match the pay of competing agencies.)

If Volcker has concluded that civil service reform, despite his best efforts, is not going to happen anytime soon, I think he is right. It usually takes a crisis for the government to change, and the problems in the civil service are slowly making things worse but are not creating a crisis. And when there is a crisis, such as in the financial sector, partial solutions can be applied, such as reorganizing some agencies and paying select government employees more money. Nevertheless, I am leery of giving more power to the Federal Reserve. I agree with much of what it has done in recent years, and I think both Ben Bernanke and Janet Yellen have been excellent in leading that organization. One does not, though, have to go back that far in history to find that the Fed has made major mistakes. Moreover, if ultimately, any particular Administration is going to be judged by how the economy performs, one should not continue a trend of giving more and more authority to agencies that the Administration does not control.

More on the Volcker Alliance Financial Regulatory Proposals

In my previous post, I criticized the Volcker Alliance report, “Reshaping the Financial Regulatory System,” for essentially being the opening salvo in a turf fight between the Fed and the Treasury. Since I agree with the report authors that the financial regulatory system should be reformed, I was disappointed with some of their specific recommendations and the seeming underlying assumption that the Federal Reserve is the best regulatory agency around and should essentially be the lead agency except when there is a financial crisis and more political entities, such as Treasury need to get involved.

There are some other comments I have on the report’s recommendations that did not fit into the main theme of the previous post.

First, the report’s recommendation that the SEC and the CFTC be merged is one with which most disinterested observers have agreed for a long time. It has long been obvious that a mistake was made when the CFTC was created in the mid-1970s from its predecessor agency, the Commodity Exchange Authority, which was part of the Agriculture Department. The advent of futures on foreign currencies and subsequently other financial instruments, which were not covered by the Commodity Exchange Act (“CEA”) at that time, made some sort of change necessary. But rather than transferring authority for futures and “commodity” options to the SEC, the CEA was modified so that the definition of “commodity” encompassed potentially almost everything imaginable (with the amusing exception of onions), including securities and indices of all sorts, while leaving the definition of “futures contract” undefined. This first led to jurisdictional issues with the SEC, which were initially papered over with the Shad-Johnson Accord in December 1981 (named after the then chairmen of the SEC and the CFTC). I remember discussing the Shad-Johnson Accord with my boss at Treasury at the time. We concluded that it resolved some existing, troubling jurisdictional issues, but that it did not solve the jurisdictional problems due to the way the CEA could be interpreted and the overlapping interests of the two agencies. We were right. (Most significantly, the lack of definition of futures contracts led to a large public debate among the CFTC and other financial regulators about whether OTC swaps were covered by the CEA. This was never resolved and has been overtaken by various amendments to the statutes which the CFTC, the SEC, and the bank regulators administer. Another provision of the CEA, known as “the Treasury Amendment” led to a dispute between the Treasury and the CFTC about it jurisdiction over OTC foreign currency options. An aspect of that dispute went to the Supreme Court in a 1997 case in which Treasury was not a party. The CFTC lost, nine to zero.)

Given that most of the contracts the CFTC now regulates are financial, it has long made sense that the SEC and the CFTC be merged. For example, it makes no sense that stock index futures and options on stock index futures are regulated by the CFTC, while option on the same stock indices are regulated by the SEC. The political problem is that the CFTC falls under the jurisdiction of the Congressional agriculture committees, which do not want to cede their authority over the CFTC.

However, while the report is right in calling for a SEC/CFTC merger, the recommendation that some of the authority that now exists with these agencies should be transferred to a new regulator is more problematic. The report recommends that a new prudential supervisory authority (“PSA”) be “responsible for supervising broker-dealers, swap dealers, FCMs [futures commission merchants], and MMFs [money market mutual funds].” (p. 36) The new SEC-CFTC merged agency would have “the current rulemaking authority of the SEC and the CFTC with respect to matters of investor protection, the structure of securities and derivatives markets, and the integrity of those markets.” (p. 36) The report is silent about whether the SEC-CFTC agency would have any examination authority.

This structure looks like one asking for turf fights. Dividing the responsibility for the structure of markets, their integrity, and investor protection from responsibility for overseeing the principle market makers and conduit to the marketplaces is unlikely to work very well. One wonders why the authors of this report, after correctly identifying that merger of the SEC and the CFTC would improve the regulatory structure, then go on to weaken the combined agency and create other problems.

Another weakness of the report is the failure to address the insurance industry and the mortgage markets. The report specifically states that regulation of the insurance industry and the mortgage markets “are beyond the scope of [the] report.” (p. 5) Perhaps, the authors were perplexed about what to do in this area, because there has no decision about Fannie Mae and Freddie Mac and reforms to insurance regulation means taking on state regulatory agencies. Nevertheless, this is a significant weakness in the report since both the mortgage market and an insurance holding company were heavily involved in the 2008 financial crisis. The involvement of the mortgage market does not require any elucidation here. With respect to insurance, an affiliate of AIG took on more risk than it can handle from other financial institution through the use of credit default swaps. This turned out to be a major problem during the financial crisis. AIG was nominally regulated by the Office of Thrift Supervision (“OTS”) as a savings and loan holding company because it owned a savings and loan, but OTS did not (and probably did not have the capacity) to do much supervision of AIG. The Dodd-Frank legislation abolished OTS and merged it with the OCC. The savings and loan holding company responsibilities were transferred to the Fed. An insurance company could fall under some federal oversight under Dodd-Frank if it is deemed to be a systemically important financial institution even if it does not own a thrift institution, but, given the large role insurance companies play in the financial system, the report’s omission of any discussion or recommendations of how they should be regulated is significant.

Another important omission of the report is the lack of any discussion of the too-big-to-fail issue, which has arguably gotten worse after the financial crisis. The report also does not discuss whether the contention that the resolution procedures of Dodd-Frank would work, especially for large, complex, international financial institutions subject to the courts and differing legal systems of multiple jurisdictions.

Finally, fewer regulatory agencies, as this report recommends (though in a flawed manner), may mitigate the regulatory capture problem but will not eliminate it. For example, of all the regulatory agencies, the Fed is the most powerful and the most able to withstand both political and industry pressure, but the evidence suggests that it is not immune from regulatory capture. (The Carmen Segarra tapes are one example; the decision to pay AIG swap counterparties in full is possibly another.)  Paul Volcker is someone ideally situated to think about and make recommendations about what to do about regulatory capture. I hope he will.

As it is, though, the Volcker Alliance is going to have to do better to contribute meaningfully to consideration of changes in the U.S. financial regulatory structure. The current report is, unfortunately, disappointing.

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.