Missing Volcker’s point

Yves Smith responds to Volcker:

The world has evolved so that many market making activities are now as essential to commerce as deposit gathering and lending. Those activities are de facto backstopped; there is simply no ready way back here (trust me, even if there were, it would take twenty years, and we’d still need an interim solution).  We need to regulate those activities aggressively, including requiring much more capital to support them …

Hmm, don’t you think that requiring an appropriate amount of capital will lead us straight to Volcker’s solution.  Already money market funds are saying that the two sensible reforms either (i) capital requirements comparable to banks, or (ii) an end to the $1 NAV will destroy the industry.  Umm, isn’t that the point?  All these so-called “market based” industries that aren’t designed to survive a crisis without a bailout from either the banking system or the government will die when they are required to, like banks, carry sufficient capital to support their credit risk exposure.

Now if you just view Volcker’s approach as step one in the “interim solution”, maybe we can get somewhere.

Economics of Contempt agrees with Yves:

The clear lesson from the financial crisis is that certain capital market institutions are every bit as important to the day-to-day functioning of the modern economy as commercial banks. That’s a positive statement, not a normative one. Lehman Brothers was not a commercial bank, and yet its failure had catastrophic consequences for the global economy.

Well, yes.  Isn’t that precisely Volcker’s point?  We need such thorough structural reform of our financial markets that (i) the failure of a capital market institution will not be a systemic event, (ii) the failure of a money market fund to pay the full amount will not be a systemic event, and (iii) if there is a failure that could be systemic, we have a resolution process that forces shareholders and creditors to bear the full cost of the failure.

EoC and Yves Smith are claiming that (i) is simply impossible.  Let’s just say that, given 150 years of financial history where such failures did take place — at the expense of shareholders and creditors — while the system survived, this view remains to be demonstrated.  The fact that change involves change, does not demonstrate that change is impossible.

EoC claims:  “Capital market institutions need to be given access to the safety net”

Which I think deserves as a response a repeat of the question EoC asks Volcker:  “I’m sorry, but were we watching the same financial crisis?”

We just learned that (i) money market funds function because commercial paper carries a guarantee from the banking system (c.f. Citi SIVs and the structure of most commercial paper programs).  (ii) The repo market functions because it carries a guarantee from the banking system.  In the absence of backing by commercial bank deposits, the repo market could not possibly have survived the crisis.  (iii) Securitization in the mortgage market requires a government backstop.

The logical conclusion to draw from this experience is that aside from old-fashioned, unstructured long-term corporate bonds, there isn’t much reason to believe that “market-based” lending exists.  The only short-term lending we have is lending backed by the banking system.  It is unlikely that mortgages (and other traditionally illiquid loans) are suited to “market-based” lending in the absence of a government or bank guarantee.  The sooner members of the financial community recognize how little market-based lending there really is — as Volcker has done — the sooner we can get to work building a functional financial system.


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