Research

Retired Citigroup CEO John Reed testified to the Senate banking committee earlier this month on “Implications of the ‘Volcker Rules’ for Financial Stability,” and what the observations of Paul Volcker and his associates about the roots of the financial crisis suggest must happen for meaningful reform. (Download transcript here.)

Some highlights:

On the causes of the crisis:

• previous assumptions about the self-preservation behaviors of large financial institutions proved false — financial institutions either didn’t or couldn’t take steps to protect themselves;
• although the interest rate environment is widely believed to have contributed to the crisis, our financial system should be designed to function properly in any interest rate scenario;
• financial services should never have been permitted to have the kind of impact on the economy as a whole that they currently have;
• there were regulatory failures galore, including: the complete failure of rating agencies; failure of supervisors to identify swaps as insurance products requiring reserves, to note alarming decapitalization of the sector, to understand counterparty risk and to regulate no doc/low doc lending; and the poor judgement of accelerating loan activity through Fannie and Freddie to “an uneconomic extent;
• unprecedented activity in securitized loans, which were intended to be sold to “knowledgeable investors” but wound up on bank’s balance sheets instead.

On effective reform:

• Capital reserve requirements should be increased dramatically — possibly doubled;
• Financial institution liquidity should be examined regularly, at least annually;
• Industry activities should be compartmentalized, keeping riskier activities (and cultures) separate from everyday banking;
• Traded instruments should be sold on public exchanges to the extent possible (improving information flow and real-time pricing);
• A consumer financial protection agency should be established.