Volcker plan to radically rethink the global financial system

By Cydney Posner

Today, a 30-member group led by Obama economic advisor Paul Volcker released a plan that would radically rethink the global financial system. According to the story copied below from the Washington Post, the report's "recommendations were immediately seen by observers as a building block to an Obama plan because the lead author is Paul Volcker, the former chairman of the Federal Reserve during the Carter and Reagan administrations who will serve as a special Obama White House adviser. Part of Volcker's role is to help mastermind what could ultimately be the biggest overhaul of the U.S. financial system in decades." The recommendations include

• elimination of regulatory gaps and weaknesses,
• prohibition of large, systemically important banking institutions from undertaking conflict-of-interest or high-risk activities such as sponsorship and management of commingled private pools of capital (hedge and private equity funds in which the banking institutions own capital is commingled with client funds),
• enhanced credit underwriting standards that require retention of a meaningful part of the credit risk in the event of participation in packaging and sale of collective debt instruments,
• prohibition of ownership or control of government-insured deposit-taking institutions by unregulated non-financial organizations,
• nationwide limits on deposit concentration to guard against excessive concentration in national banking systems (with implications for effective official oversight, management control, and effective competition),
• improved quality and effectiveness of regulation with higher levels of national and international coordination,
• registration of managers of private pools of capital that employ substantial borrowed funds (with size and VC exceptions),
• strengthening of institutional policies and standards, with particular emphasis on standards for governance, risk management, capital, and liquidity (including coordination of board oversight of compensation and risk management policies, with the aim of balancing risk-taking with prudence and the long-run interests of and returns to shareholders, and ensuring the risk management and auditing functions are fully independent and adequately resourced areas),
• reevaluation of fair value accounting principles and standards with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets,
• increased transparency of financial markets and products, with better aligned risk and incentives and more robust infrastructures supporting markets;
• oversight of credit default swaps and other exotic derivatives,
• improved transparency and disclosure for asset-backed and other structured fixed-income financial products, and
• reform of credit-rating agency, including new payment models, encouragement to users of risk ratings (especially regulated users) to acquire the capacity for independent evaluations of the risk of credit products in which they are investing, and more robust rating systems that reflect the full range of potential risk factors.

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Obama Adviser Presents Plan to Alter Global Financial System

By Anthony Faiola
Washington Post Staff Writer
Thursday, January 15, 2009; 1:41 PM

NEW YORK -- A top economic adviser to the incoming Obama administration unveiled a plan today to radically rethink the global financial system, including a host of measures that would dramatically expand government control over banking and investment in the United States.

The plan -- which recommends limiting the size of banks, setting guidelines for executive pay and regulating hedge funds -- offers the first hint of the kind of changes to the financial system President-elect Barack Obama might push for in the coming weeks and months. Obama has pledged to present a comprehensive series of changes to prevent a repeat of the current financial crisis before world leaders gather in London for a major economic summit in April.

The report today was issued by the Group of 30, an organization of international economists and policy makers. But the recommendations were immediately seen by observers as a building block to an Obama plan because the lead author is Paul Volcker, the former chairman of the Federal Reserve during the Carter and Reagan administrations who will serve as a special Obama White House adviser. Part of Volcker's role is to help mastermind what could ultimately be the biggest overhaul of the U.S. financial system in decades.

Volcker said he would press the new administration to consider the measures, "but it's up to the administration to decide what they want to do."

The proposal offers 18 major recommendations that would insert government regulators into the board rooms of financial institutions as never before. The plan recommends vastly increased oversight of major banks, going as far as to recommend the end of an era of mega banks whose size makes their failure potentially catastrophic to the global financial system. To limit their size and scope, banks, the document states, should be prohibited from managing hedge funds or private equity funds.

In addition, major mutual funds should be required to operate as commercial banks, subjecting them to stricter government oversight. Those that choose not to comply should be forced to sell only relatively safe financial instruments offering investors low risk, and, most probably, limited room for outsized profits.

The document suggests that rating agencies should also face a battery of government regulators.

"The issue posed by the present crisis is crystal clear: How can we restore strong, competitive, innovative financial markets to support global economic growth without once again risking a breakdown in market functioning so severe as to put the world economies at risk?" Volcker said in a statement. "We hope that our proposals, which explicitly relate to the weaknesses that have become evident in the financial system over the last year, will be a useful contribution to the debate about needed reforms both by private financial institutions and by public authorities."

The proposal suggests that the U.S. government should clarify the status of mortgage giants Fannie Mae and Freddie Mac, either making them into government agencies or regulating them as independent mortgage brokers.

The plan's recommendations for greater international cooperation on regulation and the creation of new laws to oversee exotic financial derivatives echo similar calls from major world leaders made during an emergency economic summit in Washington on Nov. 15. With cautious support by President Bush, plans are moving forward, for instance, to enhance international cooperation in overseeing major banks. But European leaders have eagerly awaited a signal from Obama about what his plan for creating a new set of rules for the global financial system might look like.

It remains unclear how many of the recommendations will ultimately make their way into Obama's final plan, but the proposal released today could lift the spirits of Europeans who have called for stricter government oversight on executives' pay and risk management in financial institutions -- an area where the Bush administration has offered only tepid support. The report today calls for government to enforce systematic board-level reviews for executive pay and the creation of new parameters for a firm's risk tolerance.