International Finance 15:1, 2012: pp. 125–135

DOI: 10.1111/j.1468-2362.2011.01294.x


Unfinished Business in Financial Reform∗

Paul Volcker Former Chairman, The Federal Reserve

The past two decades have witnessed a sea change in the landscape of our financial markets. At the start of the 1990s, complex financial engineering and active derivative trading was in its infancy. CDOs, CDSs, SIVs and mysterious conduits simply did not exist. Commercial banks had not yet become investment banks and investment banks had not yet acquired banking licenses. The innately conservative organizing principle for investment houses as partnerships has been dropped and increasingly aggressive and risky trading practices have come to take centre stage. In the process the major financial institutions have grown larger and larger, a lot more complicated, international in scope, interdependent, impenetrable to outsiders and I fear to directors and many senior managers as well.

Long before the 2008 financial crisis broke, many prominent, wise and experi- enced market observers used the forum provided by the now-renowned William

∗This article is adapted from a speech presented to the Group of Thirty in Washington, DC, on 23 September 2011.

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126 Paul Volcker

Taylor Memorial Lecture – which I was recently privileged to give (Volcker 2011), and around which this article is based – to express strong concerns about the implications of the greater complexity, the need to develop more sophisticated and effective approaches toward risk management and the difficult challenges for supervisors (see, e.g. Cartellieri 1996; Crockett 1998; Fisher 2002). There were concerns about the incentives toward risk-taking embedded in new com- pensation practices (and especially stock options). Significantly as early as the mid-1990s, a senior European commercial banker raised questions about the seeming decline in ethical standards (again, Cartellieri 1996). A decade later an experienced American central banker reiterated those concerns, suggesting that moral as well as practical issues were involved (McDonough 2002).

More than a decade ago, a highly respected European official raised questions about the implications for financial stability of the diminishing role for tradi- tional (and highly regulated) commercial banking (Padoa-Schioppa 1999). The unspoken assumption of many was that the new investment bankers and both hedge and equity funds would in combination be capable of providing more competitive and stable markets and a more effective allocation of capital. But, the author asked, what about a stable core for the payments system, for the provision of liquidity, and for consumer services?

One thing I found missing from the lectures was a clear expression of an intel- lectual rationale for all the changes in the financial environment. Theorizing was lacking about market efficiency and rational expectations, which together would lead to stability and the optimal allocation of resources. The Taylor authors, after all, were not academics steeped in mathematical abstractions. They were central bankers, regulators and market participants used to coping with the im- perfections, excesses and the frailties of human behaviour. None were prepared to accept a ‘hands-off’ regulatory philosophy.

The ‘old world’ surely had financial crises enough. The Latin American debt crisis of the 1980s, the savings and loan debacle and the subsequent commercial bank failures were no simple matters. A progressive breakdown in markets and lasting damage to the real economy was avoided.

That was not easy. The costs were significant. And those crises, in their severity, were a reminder of the simple fact that traditional banking, while providing essential public functions, necessarily entails risk. Those risks are inherent in intermediation between borrowers and lenders, between investors seeking longer term funds and lenders placing priority on liquidity and between obligations denominated in different currencies. It was the effort to deal with those risks that propelled much of the new financial architecture. But somehow in the effort to define, separate and diffuse those risks, with its familiar slogan of ‘slicing and dicing’, sight was lost of the fact that this risk ultimately remained, however much it was relocated and re-priced. In fact, risk sometimes ended up in new


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