Even if policymakers reduce the size and scope of the largest banks, systemic risk is here to stay, former Federal Reserve Board chairman Paul Volcker said Thursday.
Mr. Volcker, whose comments came at a press conference to release a report recommending improvements in global financial regulation, clearly supported the efforts to shrink Citigroup Inc. but added that it is "impractical" to try to reduce large banks enough so they no longer pose a threat to the system.
Mr. Volcker said the advice of the 18th century economist Adam Smith to handle banks' risks by "keep[ing] them small" is inappropriate for the present-day economy.
"That advice might have been suitable in 1776 in Scotland, but it would be difficult to apply here in the modern United States," he said.
But this does not mean he favored giving large institutions a free hand. A 68-page report issued by the Group of 30, a group of international economists that includes Mr. Volcker, said regulators must bar banks from taking actions that "present particularly high risks and serious conflicts of interest."
"Sponsorship and management of commingled private pools of capital … should ordinarily be prohibited," the report said, "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."
Mr. Volcker said the efforts to reduce Citi's scope are closely aligned with the philosophy behind his group's report.
"Reading the paper about Citigroup's plans, it sounded like a lot of that could be lifted from our report," he said.
The report also called for stepping up the power of central banks worldwide, arguing that they should "accept a role in promoting and maintaining financial stability." Exactly how much power the central bank should have is much-debated.
Outgoing Treasury Secretary Henry Paulson offered a "blueprint" for regulatory reform last year that would establish the Fed as a systemic risk regulator but strip away its bank supervision powers. Fed Chairman Ben Bernanke has argued, however, that the central bank must keep its supervisory authority to effectively conduct monetary policy.
The report took no definitive stand on the issue but said that, at a minimum, all central banks should have a role in prudential regulation and bolstering financial stability.
"After this crisis, central banks will have to be more actively concerned with financial stability than they were before the crisis and, hopefully, less involved than they have been during the crisis," said Tommaso Padoa-Schioppa, the vice chairman of the committee that developed the report. (He is a former minister of economy and finance in Italy.)
The report also urged that central banks have a "supervisory role in regard to the largest systemically significant firms, and critical payment and clearing systems."
The Group of 30 also seemed to support a suggestion from Mr. Paulson last week that Fannie Mae and Freddie Mac be converted into private companies regulated along the lines of a public utility.
"Hybrids of private ownership with government sponsorship should be avoided," the report said. "In time, existing [government-sponsored enterprise] 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."
The group criticized fair value accounting, saying it does not work when there is no market for certain assets.
Accounting principles "should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets," it said.
The report also said money market mutual funds wishing to offer services similar to banks' "should be required to reorganize as special-purpose banks."
The new entities would have "appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities."
The institutions that remain traditional money market funds should only invest conservatively, the report said, "with modest upside potential at relatively low risk."