Moral Hazard and the Crisis

Editor's note: The following is from the keynote address by former Federal Reserve Chairman Paul A. Volcker to a meeting of the International Institute of Finance in Beijing, June 11:

Another important common concern is the "too big to fail" syndrome -- the presumption that an institution is so large or so inter-connected with counterparties that its creditors (possibly even shareholders) must be protected. One unfortunate consequence of the massive public assistance provided both banks and nonbanks in dealing with the present crisis is that moral hazard may, I am afraid, become more deeply embedded.

We can, and we should, take steps to limit the need and possibility of official "bailouts." One approach would be to set clear policy limits to access to the "official safety net." Deposit insurance and central bank liquidity facilities are properly confined to deposit-taking institutions. It is, after all, those institutions that remain the backbone of the financial system. They provide basic essential services, meeting the needs of households, businesses and other institutions for credit, for a safe and liquid repository for their funds, and for both everyday and complex payment services.

Historically, the need for continuity in those functions has provided the rationale for close government supervision and protection. In my view, it is unwarranted that those same institutions, funded in substantial part by taxpayer-protected deposits, be engaged in substantial risk-prone proprietary trading and speculative activities that may also raise questions of virtually unmanageable conflicts of interest.

Hedge funds and private-equity funds have an entirely legitimate role to play in providing liquidity and innovation in our capital markets. I do not believe they need to be so closely supervised and regulated as depository institutions. A presumption of government protection and support for financial institutions outside the "safety net" should be avoided. Nor by the same token should hedge funds or private-equity funds indirectly benefit from official support by sponsorship or ownership by a banking institution.

The possibility that failure of a large hedge fund or trading organization might present a systemic risk can be reduced by way of speeding timely resolution of troubled nonbanking institutions. Such authority already exists in the United States for insured banking institutions by means of appointing a "conservator" or "receiver" empowered to maintain continuity of services pending a more lasting resolution of a failing institution.

There is a growing international consensus that hedge funds and equity funds beyond some de minimus size should at least be required to register, with the implication of limited reporting requirements. There may be a few instances in which such funds become so large as to suggest official capital and leverage requirements would be appropriate. Hedge and private-equity funds are necessarily dependent on banks for credit and operational needs. Encouraged by supervisory and risk-management processes, such funds could be appropriately monitored and controlled through those banking relationships.

One other hotly contested matter deserves mention. There isn't much doubt that attempts to enforce strict application of mark-to-market accounting procedures has contributed to confusion, uncertainty and inconsistencies among financial institutions. There is a strong case for reviewing the application of so-called fair value standards to commercial banks, insurance companies and perhaps certain other regulated financial institutions.

The problem is not only the difficulty of measuring value in highly disturbed market conditions. More broadly, strict mark-to-market accounting -- entirely appropriate for trading operations and investment banks -- may introduce a degree of volatility in reporting incompatible with the basic and essential business model of banks, which inherently intermediate maturity and credit risks.

At the same time, we should demand international consistency and professional judgment in setting accounting standards. Both are today jeopardized. Political bodies in Europe or the United States or any other country are simply not the appropriate venue for reaching well-considered judgments that can be enforced internationally. Instead, we need a bit of patience as the International Accounting Standards Board carefully reviews the application of "fair value" to banks and those other institutions subject to close official scrutiny in reporting.

This has been a heavy talk after a splendid dinner in this Great Hall. My excuse is simple, you have a very long, very technical agenda, and I am delighted to be able to get a few words in first.

I appreciate your attention.