WASHINGTON — Paul Volcker, the chairman of the President's Economic Recovery Advisory Board, plans to fight back Tuesday against criticisms of his proposal to ban banks from proprietary trading and other speculative trading, arguing his plan is the best way to minimize risk in the banking system.
Scheduled to appear before the Senate Banking Committee later this afternoon, Volcker offered a point by point defense of the plan in written testimony, saying it would still allow plenty of ways for banks to make money and would not leave banks at a competitive disadvantage internationally.
While conceding that his plan would require "strong international consensus… particularly across those few nations hosting large multi-national banks and active financial markets," he said that was within reach.
"Judging from what we know and read about the attitude of a number of responsible officials and commentators, I believe there are substantial grounds to anticipate success as the approach is fully understood," he said in written testimony.
Volcker also responded to criticism that it would be difficult to define the types of risky pools of capital that would be impermissible for banks to own, arguing it would be straightforward for regulators to assess. Volcker cautioned, however, that regulators would need to remain on guard for bankers to try and find ways to skirt the spirit of the rules by coming up with new pools of capital that escaped the rule's definition.
"The functional definition of hedge funds and private equity funds that commercial banks would be forbidden to own or sponsor is not difficult," he said. "Authority provided to the appropriate supervisory agency should be carefully specified. It also needs to be broad enough to encompass efforts sure to come to circumvent the intent of the law. We do not need or want a new breed of bank-based funds that in all but name would function as hedge or equity funds."
He also flatly rejected the claim that defining proprietary trading would be tricky.
"Every banker I speak with knows very well what 'proprietary trading' means and implies," said Volcker.
Volcker estimated that only a handful of large commercial banks — maybe four or five in the U.S. and perhaps a couple of dozen worldwide — are engaged in this activity in volume and some already label trading affiliates "proprietary."
Most of those institutions and many others meet their customers' needs by buying or selling securities, derivatives, various commodities or other investments that may involve taking temporary positions where there are temptations to speculate aggressively, he said.
But Volcker said with "strong legislative direction, bank supervisors should be able to appraise the nature of those trading activities and contain excesses."
He suggested that regulators should analyze the volume of trades relative to customer relationships and the relative volatility of gains and losses of such activity, then impose "substantially raised capital requirements" when they find "patterns of exceptionally large gains and losses" over time.
To bolster his case, he highlighted what he called strong conflicts of interest between proprietary and private investment activity in commercial banks, arguing that it creates perverse side effects that are risky to the market and enables banks to unfairly profit from knowledge of customer trades.
"When the bank itself is a 'customer', i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank," he said. "'Inside' hedge funds and equity funds with outside partners may generate generous fees for the bank without the test of market pricing, and those same 'inside' funds may be favored over outside competition in placing funds for clients."
Volcker acknowledged that even with such safeguards, risk would not be removed from the banking industry.
"I am not so naive as to think that all potential conflicts can or should be expunged from banking or other businesses," he said. "But neither am I so naïve as to think that, even with the best efforts of boards and management, so-called Chinese Walls can remain impermeable against the pressures to seek maximum profit and personal remuneration."