Should banks go back to being just, well, banks? Former Federal Reserve System Chairman and chair of President Obama’s Economic Recovery Advisory Board thinks so. Here are his new thoughts on an old idea.

Commercial banks should stick to their core functions as depositories and providers of credit, and stop conducting inappropriately risky activities including proprietary trading, believes Paul Volcker, former chairman of the Federal Reserve System.

Volcker, who is chairman of President Obama’s Economic Recovery Advisory Board, told CME Group’s second annual Global Financial Leadership Conference that when commercial banks ventured into capital markets functions, their risks grew too high. Volcker’s presentation at the conference foreshadowed the Obama Administration’s move in January, which proposed the so-called “Volcker Rule” aimed at limiting banks’ size and prohibiting their proprietary trading.

“Commercial banks adopted a lot of the functions that I would argue more properly belong in the capital markets, which greatly increased the complexity of those institutions,” Volcker says.

Volcker believes that this complexity made the banks’ activities more difficult to manage and supervise, and gave rise to moral hazard – taking on excessive risk in order to make more money.

“Risk management in banks and other companies was obviously not up to the task of controlling the complexity of the current markets. Neither were the regulators,” Volcker adds, advocating tougher capital standards, not just in the United States but globally, along with a method of controlling systemic risk.

REDEFINING THE ROLE

The role of commercial banks is fundamental to maintaining a healthy economy. Acting as they do supports other financial market activities. But, Volcker argues, these functions should be separate from other financial activities.

“Let’s get rid of what seems to me extraneous financial activity from the standpoint of commercial banking,” says Volcker. By this he means hedge funds, private equity funds and proprietary trading in securities or commodities.

“These are appropriate activities to be undertaken by the market generally. The question is whether they are appropriate activities for commercial banks, adding a layer of complexity, risk and conflict of interest that simply was not necessary,” he says.

If capital markets activities such as proprietary trading were stripped out of commercial banks they would be smaller, he acknowledges, but the advantage is that there are existing apparatus for the protection of the banking system.

Hedge funds, private equity funds and proprietary trading could be shifted into separate companies where they would have the freedom to trade without, in general, creating systemic risk. “Let them go out and practice their business, make money, support other businesses, hedge, don’t hedge, whatever they want to do and contribute to a fluid market without serious systemic risk,” says Volcker.

Bank basics

Volcker would like to see banks getting back to basics in a customer relationship function and also believes commercial banks should be allowed to do advisory work such as mergers and acquisitions.

“I do believe in the separation between the commercial banking system and the capital market,” says Volcker.

However, this separation of commercial banking and capital markets activities is not the same thing as the Glass-Steagall Banking Act of 1933. That act separated banks by activities – commercial and investment banking – and it founded the Federal Deposit Insurance Corporation for insuring bank deposits. That was a very different time, says Volcker: “In an earlier age we hadn’t invented all this other stuff; we didn’t have hedge funds, equity funds, we didn’t have a lot of proprietary trading.”

Even capital markets-only firms could grow large enough to present systemic issues, therefore an appropriate government agency should have authority to step in when leverage was too high, or speculative risk was too great, says Volcker. Therefore Volcker is a supporter of systemic oversight, and says that a systemic risk regulator should look at the whole financial system rather than regulating it piecemeal.

“They look here, there, but nobody looks at the interactions in the system as a whole, or nobody did it very systematically.”

A systemic regulator could judge when things go wrong or an action needs to be taken by the appropriate authority. Volcker is also a fan of resolution authority if a large institution is in danger of failing and could contaminate the rest of the financial system. He wants an agency that can step in when needed with the appropriate powers and take control of that institution, by some kind of liquidation mechanism or conservatorship.

“We are not going to sustain the institution by government assistance, no more, in that sense, too big to fail,” he says.

The U.S. economy is out of the operating room, says Volcker, and maybe even out of intensive care. But it is not back to normality. Volcker notes that the United States must move away from its dependency upon consumption to an economy that can export more and replace some imports.

“It is a system that needs reform,” Volcker says. “This is not a normal situation, it is a breakdown. It is an uncomfortable situation and we don’t want it to happen again.”