Paul Volcker: ring-fencing won't work

In an exclusive interview with the Telegraph, Paul Volcker said that when a financial crisis hits ring-fencing retail from investment banking won't protect the financial system.

As a practical matter, neither will the current version of the Volcker Rule which relies on complicated rules and regulatory supervision to protect the financial system.

Regular readers know that combining either the Volcker Rule or ring-fencing with ultra transparency would protect the financial system.

By requiring the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants could exert discipline on the banks to restrain their risk taking.

Restraining risk taking happens to not be in conflict with market making.  Banks will still be able to make markets, they will just be restrained when it comes to making proprietary bets.

In an exclusive interview with The Daily Telegraph, Mr Volcker said that plans to force banks in the UK to ring-fence their traditional retail arms from "casino" investment divisions would not work in the event of a bail out. Ringfencing, he said, would only work in "fair-weather" conditions but not when banks were under pressure. 

"In my experience ring-fencing is not terribly effective," said Mr Volcker. "It only works in fair-weather. But doesn't work in foul weather. They have already run into problems and they are bound to run into more." ...

Mr Volcker said: "John (Vickers) and I have the same concerns in mind. But the logic would be to separate the two parts of banking, not to keep them within the same institution. I find it puzzling to suggest that within one organisation you can have a branch that is entirely independent of another subsidiary, with the confidence that never the twain shall meet?" 

Mr Volcker said that it was unclear how the two parts of banking could be entirely independent when under ring fencing they would be subordinated to the holding company. 

"I think they bowed to practicality. But Vickers will now have to define what is allowed in the relationships between the two subsidiaries. 

"Ultimately, there is a natural instinct to have a close relationship within a bank. And this is particularly true when the bank is under pressure. By the time the banks look at Vickers they will think that Volcker looks better."

In the US, the "Volcker Rule" – the precursor to Vickers - advocates an outright ban on all forms of risky investment activity on the bank's own account, such as proprietary trading. 

The rule, part of the Dodd-Frank act is yet to be finalised and has drawn scathing remarks from banking bosses.

Whether you try to split the banks into subsidiaries or try to ban proprietary trading, what ultimately is most effective in reducing the risk of the banks is to require them to provide ultra transparency.

With ultra transparency, market participants can independently assess the risk of each bank and adjust the amount and price of their exposures to each bank to reflect this risk.  Banks with more risk will pay a higher price to attract funds.

Update
Confirmation that publicizing trade position under ultra transparency will reduce if not completely eliminate proprietary trading comes from a Risk magazine article.

Real-time or near-real-time [think before the beginning of the next business day] publication of transaction data, as proposed in a review of the Markets in Financial Instruments Directive, could cause market makers to shy away from less liquid trades and shrink trade size of over-the-counter derivatives. The motivation would be to avoid revealing trading positions.