Failing US financial institutions must face the credible threat of government closure if reforms are to succeed, a key adviser to President Barack Obama said Tuesday.
Paul Volcker, a former Federal Reserve chairman, said reforms being discussed by Congress hit on the “essential elements” of financial reform, but that a strong government arbitrator must emerge with the power to wind down firms.
“There is a clear need for a so-called resolution authority,” Volcker told members of the Peterson Institute for International Economics, a Washington-based think tank.
Volcker said that massive government bailouts of insurance giant AIG and other non-bank firms had raised expectations of a government safety net, which could deaden fear of failure and create a so-called “moral hazard.”
“There is an expectation that very large and complicated financial institutions will not be allowed to fail,” Volcker said.
“Unless that conviction is shaken, the natural result is that risk taking will be encouraged and in fact subsidized… and we may be headed full speed into the next crisis some years ahead.
“That seems to me to be the core challenge of financial reform.”
While Volcker said the government should have the power to step in to bolster banks if needed, “ultimately the failing firm should be liquidated or merged. In all… it is a death sentence, not a rescue at the hospital.”
Obama is pushing Congress to pass sweeping reforms of the financial sector, as he taps into public anger at the role banks played in spurring the worst recession in a generation.
The president on Tuesday again urged lawmakers to forge ahead when they return from recess on April 12.
“I look forward to the Senate taking action on this landmark legislation, so we never repeat the mistakes that led to this crisis,” he said.
“We must provide sufficient oversight so that reckless speculation or reckless risk taking by a few big players in financial markets will never again threaten the global economy or burden taxpayers.”
Volcker has been at the forefront of Obama’s efforts to provide that oversight, heading an influential economic recovery panel.
The former Fed chairman has advocated stopping banks from holding customers’ deposits at the same time as making investments for their own gain — so-called proprietary trading.
Curbs on “prop trading” had been in effect since the Great Depression. In 1933 Glass-Steagall Act prohibited commercial banks from underwriting corporate securities, or acting as brokerages.
But the rules were overturned in 1999, during the administration of president Bill Clinton.
In January Obama backed the “Volcker rule” against proprietary trading as “a simple and common-sense reform.”
Volcker, an octogenarian who headed the Fed from 1979 to 1987, supported Obama during his Democratic bid for the presidency and subsequently was tapped to head the President’s Economic Recovery Advisory Board, an independent, nonpartisan body created to tackle the worst recession in decades.