How Mr. Volcker Would Fix It
Published: October 22, 2011

AMID all the minutiae of the Dodd-Frank financial overhaul, it’s easy to lose sight of the big question: will consumers, investors and the economy be safer?

That’s why a recent speech by Paul A. Volcker, the former chairman of the Federal Reserve and a voice of reason on matters financial, is so timely and important. Presented last month to the Group of 30, an organization devoted to international economic issues, the speech outlined crucial work that still must be done to safeguard our financial future. “Three Years Later: Unfinished Business in Financial Reform” was the title.

“By now it is pretty clear that it was faith in the techniques of modern finance, stoked in part by the apparent huge financial rewards, that enabled the extremes of leverage, the economic imbalances and the pretenses of the credit rating agencies to persist so long,” Mr. Volcker said in this remarkably candid talk.

The real treasures were found in his to-do list for further reforms. That heavy lifting includes addressing capital requirements (make them tough and enforceable), derivatives (make them more standardized and transparent) and auditors (ensure that they are truly independent by rotating them periodically).

He also spoke of the perils of institutions that are too large or interconnected to be allowed to fail. Calling this the greatest structural challenge facing the financial system, he said we must shrink the risks these companies pose, “whether by reducing their size, curtailing their interconnections or limiting their activities.”

He also saw other economic fault lines, which are worth highlighting because few in Washington or on Wall Street seem willing to discuss them. I asked him last week to elaborate on these hazards.

One is the potential for problems in the huge industry of money market mutual funds, which operates “in the shadows of the banking system,” he said. Although these funds are typically managed conservatively, he said, they are vulnerable to runs, as occurred when Lehman Brothers collapsed.

“Because they are not subject to reserve requirements and capital requirements, they are a point of vulnerability in the system,” he said. “It is really interesting that they did so much lending to European banks. They had to pull back a lot, aggravating the pressures on the European banks.”

Money market funds held $2.63 trillion as of last Wednesday, and, Mr. Volcker said, many people mistakenly think that these funds are as safe as bank accounts. But the safeguards on bank deposits — strong bank capital requirements and federal deposit insurance, for example — do not exist for most money market funds. There is also little official surveillance of the funds’ investment practices.

The sellers of money funds, of course, do not want to face these kinds of regulations or requirements. In a recent letter to the Financial Stability Board, an international organization charged with developing strong regulatory and supervisory policies for financial institutions, the Investment Company Institute said: “We do not believe banklike regulation is appropriate, necessary or workable for funds registered under the Investment Company Act of 1940.”

An alternative, Mr. Volcker said, would be to require money market funds to value their assets every day to reflect market fluctuations. This would put an end to the idea that if you put $1 into a money market fund you will always get $1 out, no matter what.

“It seems to me if you are a mutual fund, you should act like a mutual fund instead of a pseudobank,” he said.

THE other area that cries out for change, Mr. Volcker said, is the nation’s mortgage market, now controlled by Fannie Mae and Freddie Mac, the taxpayer-owned mortgage giants.

“We simply should not countenance a residential mortgage market, the largest part of our capital market, dominated by so-called government-sponsored enterprises,” Mr. Volcker said in his speech. “The financial breakdown was in fact triggered by extremely lax, government-tolerated underwriting standards, an important ingredient in the housing bubble.”

While he acknowledges that we cannot eliminate Fannie and Freddie anytime soon, “it is important that planning proceed now on the assumption that government-sponsored enterprises will no longer be a part of the structure of the market,” he said.

Welcome to the kind of straight talk that few in Washington want to hear. “This is an opportunity to get rid of institutions that shouldn’t exist,” he told me. “You ought to be either public or private; don’t mix up private profit-making opportunities with an institution that is going to be protected by the government but not controlled by it.”

Mr. Volcker knows more than a little about Fannie and Freddie; in the late 1960s and early ’70s, when he was an under secretary of the Treasury, he was among the presidential appointees to Fannie Mae’s board, he said.

The government erred, he said, by not putting the operations of Fannie Mae and Freddie Mac on the balance sheet and income statement of the United States. “They didn’t want the mortgage to be a government expenditure,” he said. “It was a volatile thing to put on the budget. They made the wrong choice.”

This is precisely the discussion we should be having on the government’s approach to housing policy. That is, unless you are a fan of the status quo, as many in Washington are, and are comfortable leaving the risk of mortgage losses on taxpayers’ shoulders.

“If the government wants to guarantee mortgages for certain low-income people, O.K., but I wouldn’t do much of it,” Mr. Volcker said. “A public agency intervening in the mortgage market in a limited way doesn’t bother me. But if you want to subsidize the mortgage market, do it more directly than hiding it in a quasi-private institution.”

When a man with the credibility and stature of Mr. Volcker talks, people in positions of power ought to listen. We’ll see if they do.