The Volcker Revolution - Providing Some Much Needed Answers
While many pundits will obsess over the markets' gyration in this past week, and make it into a major headline in the quest for eyeballs, the truth is that the S&P turning negative for the year was merely a sideshow (the next real market crash will be much more memorable). No - the real story was the advent of Paul Volcker to his rightful place on the, well, right of President Obama, coupled with the now imminent departure of Geithner and Summers, and the massive question mark that now hangs over Goldman Sachs. Who could have believed that the implications of one Senatorial election could be so profound, yet that is precisely the stuff black swans are made of. The new regime is here, and like it or not, it brings with it a new framework of variables. Yet shifting from the past and looking at the future, the question now becomes what should investors focus on? Just who is this Paul Volcker who will now be the President's seemingly primary economic advisor, and more importantly, what will his policies be like? Luckily, an extensive blueprint already exists, and Zero Hedge readers should be quite familiar with it by now.
In early January we discussed the very pertinent topic of money market funds, and as a resource to validate our view we reflected upon a little known paper written by the Group of 30, of which Paul Volcker (and Tim Geithner, and Larry Summers) are key members of. The members of the Group of 30 are precisely the same people who seem to make up Tim Geithner speed-dial rolodex, as disclosed earlier. In essence, the Group of 30 is the think tank that provide the theory for various policy-implementation platforms in high-finance society (usually these are necessarily ones that end up as a benefit to certain very critical Wall Street enterprises). The paper in question should serve as the 18 commandments for all who wonder just what it is that will be implemented as firm policy by an administration near year (even if, as Barny Frank claims, all will eventually be undone by the next administration).
The paper in question is "Financial Reform - A Framework for Financial Stability" and provides for a very insightful read into how regulatory reform will likely look going forward (sorry Barney, another thing that happened this week is that the President in essence said you can take your "sweeping financial overhaul" and shove it). One thing that the paper provides, for example, is much needed clarity, although not the full answer, into the definition of prop trading (are you reading yet Lloyd?):
Large, systemically important banking institutions should be restricted in undertaking proprietary activities that present particularly high risks and serious conflicts of interest. Sponsorship and management of commingled private pools of capital (that is, hedge and private equity funds in which the banking institutions own capital is commingled with client funds) should ordinarily be prohibited and large proprietary trading should be limited by strict capital and liquidity requirements. Participation in packaging and sale of collective debt instruments should require the retention of a meaningful part of the credit risk.
Sorry guys, but according to this the Goldman prop desk better be looking for a job stat.
Yet the paper does not end there, and it touches upon numerous fascinating aspects of overall financial overhaul, compared to which Barney Frank's magnum opus stands out like the corrupt 1,100 page contrivance that talks a lot, does nothing, and in fact provides even greater benefits to the existing financial organizations.
Topics covered include:
To guard against excessive concentration in national banking systems, with implications for effective official oversight, management control, and effective competition, nationwide limits on deposit concentration should be considered at a level appropriate to individual countries.
Money markets (and yes, Volcker's vendetta with money markets was extensively discussed previously)
Money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special-purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities.
For funds above a size judged to be potentially systemically significant, the prudential regulator should have authority to establish appropriate standards for capital, liquidity, and risk management... For these purposes, the jurisdiction of the appropriate prudential regulator should be based on the primary business location of the manager of such funds, regardless of the legal domicile of the funds themselves.
GSEs (a core topic that has so far been completely untouched in the current Frank gobbledygook, and one which Barney Frank wants to apply a sledgehammer to - why not, GSEs after all account for nearly the same amount of nationalized balance sheet risk as the Federal Reserve itself)
For the United States, the policy resolution of the appropriate role of GSEs in mortgage finance should be based on a clear separation of the functions of private sector mortgage finance risk intermediation from government sector guarantees or insurance of mortgage credit risk. Governmental entities providing support for the mortgage market by means of market purchases should have explicit statutory backing and financial support. Hybrids of private ownership with government sponsorship should be avoided. In time, existing GSE mortgage purchasing and portfolio activities should be spun off to private sector entities, with the government, if it desires, maintaining a capacity to intervene in the market through a wholly owned public institution.
Simplification of international structure:
In all cases, countries should explicitly reaffirm the insulation of national regulatory authorities from political and market pressures and reassess the need for improving the quality and adequacy of resources available to such authorities.
Central Bank lender of last resrort status and collateral transparency requirements (read this Alan Grayson):
Central bank liquidity support operations should be limited to forms that do not entail lending against or the outright purchase of high-risk assets, or other forms of long-term direct or indirect capital support. In principle, those forms of support are more appropriately provided by directly accountable government entities. In practice, to the extent the central bank is the only entity with the resources and authority to act quickly to provide this form of systemic support, there should be subsequent approval of an appropriate governmental entity with the consequent risk transfer to that entity. Central bank emergency lending authority for highly unusual and exigent circumstances should be preserved, but should include, by law or practice, support by appropriate political authorities for the use of such authority in extending such credit to non-bank institutions.
Strengthening boards of directors with greater engagement of independent members having financial industry and risk management expertise; Conducting periodic reviews of a firm’s potential vulnerability to risk arising from credit concentrations, excessive maturity mismatches, excessive leverage, or undue reliance on asset market liquidity; Ensuring that all large firms have the capacity to continuously monitor, within a matter of hours, their largest counterparty credit exposures on an enterprisewide basis and to make that information available, as appropriate, to its senior management, its board, and its prudential regulator and central bank;
Liquidity Risk Management:
Base-level liquidity standards should incorporate norms for maintaining a sizable diversified mix of long-term funding and an available cushion of highly liquid unencumbered assets. Once such standards are developed, consideration should be given to what is the preferred mix of senior and subordinated debt in bank capital structures.
Fair Value Accounting:
Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets...There should be full transparency of the manner in which reserves are determined and allocated. As emphasized in the third report of the CRMPG, under any and all standards of accounting and under any and all market conditions, individual financial institutions must ensure that wholly adequate resources, insulated by fail-safe independent decision-making authority, are at the center of the valuation and price verification process.
Off-Balance-Sheet Vehicles: Pending accounting rule changes for the consolidation of many types of off-balance-sheet vehicles represent a positive and needed improvement. It is important, before they are fully implemented, that careful consideration be given to how these rules are likely to impact efforts to restore the viability of securitized credit markets.
Regulators should encourage the development of payment models that improve the alignment of incentives among the providers of risk ratings and their clients and users, and permit users to hold NRSROs accountable for the quality of their work product.
Much-needed planned improvements to the infrastructure supporting the OTC derivatives markets should be further supported by legislation to establish a formal system of regulation and oversight of such markets.
No more TBTF: Resolution Mechanism for Financial Institutions:
In the United States, legislation should establish a process for managing the resolution of failed non-depository financial institutions (including non-bank affiliates within a bank holding company structure) comparable to the process for depository institutions...The regime for non-depository financial institutions should apply only to those few organizations whose failure might reasonably be considered to pose a threat to the financial system and therefore subject to official regulation.
Structured Products (or how to protect idiot investors from themselves and vulture banks offloading toxic crap - ref. Iceland):
The appropriate national regulator should, in conjunction with investors, determine what information is material to investors in these products and should consider enhancing existing rules or adopt new rules that ensure disclosure of that information, for both asset-backed and synthetic structured products.
And maybe most important, freedom and sharing of information
Efforts to restore investor confidence in the workings of these markets suggest a need to revisit evaluations of the costs and benefits of infrastructure investments that would facilitate a much higher level of transparency around activity levels, traded prices, and related valuations. Part of the costs of such changes is the impact on firm-specific concerns regarding the private nature of their market activity. These concerns, and direct investment costs, need to be weighed against the potential benefits of higher levels of market transparency.
Yet what is stunning is that in 29 pages, including 4 pages of bios, and several index and cover pages, Volcker managed to include enough policy proposals that could and should be the framework for a comprehensive overhaul of all that is broken in the American financial system. He also manages to shame Barney Frank with his 1,1XX pages of irrelevant ramblings (hopefully to resignation).
Volcker has already succeeded on prop trading: there are 17 other proposals remaining, which if implement by Obama, would finally indicate that this president is truly for change, and is not merely a puppet of the D.C./Wall Street corrupt political-hybrid machine.