Parliamentary Commission on Banking Standards - Minutes of EvidenceHL Paper 27-III/HC 175-III

Back to Report

Oral Evidence

Taken before the Parliamentary Commission on Banking

on Wednesday 17 October 2012

Members present:

Mr Andrew Tyrie (Chair)

Mark Garnier

Mr Andrew Love

Mr Pat McFadden

John Thurso

________________

Examination of Witnesses

Witnesses: Paul Volcker gave evidence.

Chair: First of all, Mr Volcker, thank you very much for coming to give evidence to us this afternoon. When I saw that you were in Britain, it crossed my mind that you might be taking an interest in that vacancy at the Bank of England. I am sure you feel that you have done your stint in that sort of work.

Paul Volcker: It’s for somebody who is less than 85.

Baroness Kramer: That’s young where we come from.

Q53 Chair: Yes, it is.

It is generally agreed that you are one of the clearest thinkers in this field in your generation-probably in several generations. You are also probably one of the most experienced practitioners that we will take evidence from; perhaps the most experienced practitioner. We are all very grateful to you for coming.

Can I begin by asking you about one aspect of the very interesting piece of evidence that you provided to us? This is the three-page sheet that we will shortly be publishing. Item 3 of section D states: "Based on the American experience, the concept that different subsidiaries of a single commercial banking organization can maintain total independence either in practice or in public perception is difficult to sustain." Is that gentlemanly code for, "A ring fence will not work and we have to go for full separation"?

Paul Volcker: It is a little much to say that it will not work. They tend to be permeable over time. If you really want to separate some operations very clearly and decisively, you put them in different organisations. In my experience, you do not put two functions in the same organisation and say that they cannot talk to each other or interact.

We have never had anything quite as comprehensive, if that is the right word, as a ring fence, but we have had different subsidiaries of a banking organisation with prohibitions on their ability to interact with the bank, or with rules presumably to ensure arm’s length transactions. In my experience, those arrangements tend to break down because the pressure from the institution itself is always to weaken distinctions. This is a little bit ironic, in terms of traditional Federal Reserve doctrine, but as we moved away from a concentration on traditional commercial banks to everybody putting the functions into subsidiaries, the Federal Reserve rule, in theory at least, was that we would not permit another class of subsidiary unless we were convinced that that subsidiary would provide support for the bank in times of need. What you are worried about here is the bank providing support for the subsidiary.

Let me just repeat a little homily that I used to hear from a very prominent American banker, who worked to expand the horizon of a bank holding company. He made the simple point that if the name is on the institution, or parts of the institution, it will be protected; to the extent possible, each part will be protected. If your name is on the door, you are going to protect it. As I understand it, under the philosophy of Vickers and Liikanen that would not happen. I think Britain is going a little bit uphill.

Q54 Chair: You say the ring fence would be permeable over time. Does that mean it is worth a try?

Paul Volcker: It is up to you if you want to try it. I am not saying that it would be totally ineffective; I do not mean to suggest that. But when I read Vickers, who I am no great expert on, the Treasury paper, or Liikanen, they all say, "We are going to have a ring fence, but we are going to have exceptions to it." That is where the problem begins. I understand the need for exceptions, but that kind of gives leverage. I will forecast, without any question at all, that once you do this, if you have these exceptions, the banks will say, "Yes, we must make this exception a little bigger. This is a little awkward, and we must do it for efficiency reasons or to serve the customer." It depends on how you do it, but potentially you could certainly have the same customer in two parts of the same organisation. To think that neither part of the organisation is going to take account of that when dealing with that customer seems to be a little strained.

Q55 Chair: I think we can infer from what you have said so far that you certainly have a strong preference for separation, rather than a ring fence.

Paul Volcker: Reading the proposals, in any case, my reaction was that I understand why you want the separation. The basic point seemed to be, "Okay, put it in a different company. Don’t keep them both in the same company," but I presume that for some reason there was a feeling that that was not realistic.

Q56 Chair: That opens up the next question, which is: what should be separated? You are on record as saying that pulling out as much as the Vickers report is proposing would be tantamount to another Glass-Steagall, and you have described that as "radical" and neither necessary nor desirable. Could you explain why?

Paul Volcker: My philosophy-I am talking about me, but I think this is a philosophy that is embodied in American law now-is that these banking institutions have customer relationships that, historically, they have always been proud of. They see it as central to their work that they have an established relationship. I think that implies a fiduciary responsibility. You have to worry about the welfare of your customer, and you do worry about it, much longer than a lot of trading guys-or you should do, at any rate.

Trading activity, and proprietary trading activity in particular, does not carry any sense of fiduciary responsibility. You are trying to out-trade the other guy. It is a very impersonal relationship, where somebody wins and somebody loses on particular transactions, but there is no continuing relationship-it is all episodic. I think, in part, that is where banks got in trouble, as that kind of activity became attractive-dare I say dominant-in some institutions. It employed a different form of compensation-heavily incentivised, very high levels of compensation-that inevitably affected the rest of the organisation. My theory is: take that counterparty stuff out of the organisation. Lots of other people in the market can do that-the banks do not have to-so let them fail.

It comes back to the core part. Philosophically, I think this is all consistent with Vickers. The part that is protected should not be engaged in proprietary activity for its own account. The protected stuff is protected because it provides a necessary public service: it takes care of the payment system. It is a very important function-not very glamorous, but more and more important in a globalised world. Money is shifting all over the place; it has got to be done quickly, safely and with security, and that is what banks do-it is a big part of big banks’ business. They obviously make loans, and nobody else-at least in the United States, and I think also in the UK-is equally committed to making loans to small and medium-sized businesses; they make loans to big businesses too.

Finally, they are depositories, and a depository tends to be insured, either before or during a crisis, because it is important to protect people with their liquid money, and give them a safe place to put it. Those are all public functions that are protected in practically every place, and when push comes to shove in a crisis, they get doubly protected, as Governments tend to intercede and protect the institution. But you should not do that when people are just engaged in trading on their own account, without any clear public responsibility, as I see it. That is the heart of the matter: my separation is between customer, stuff, and proprietary functions.

Q57 Lord Turnbull: Mr Volcker, I am very pleased that you have, at this time, come to the UK to give evidence, because I think we suffer from a major confusion that I think you can help us to sort out.

We have a caricature that says, "The US is returning to Glass-Steagall, following the advice of the extremely eminent Mr Paul Volcker. We have, in the Independent Commission on Banking, a halfway house that is nothing like radical enough-it should go the whole hog and adopt Mr Volcker’s proposals."

It seems to me that that is a completely wrong characterisation. I think that you are saying-I wonder if you can confirm it-that there can be a wide range of functions in the core bank, alongside the payment system, and then there are another set of types of transactions that really should not be there at all. If they are not there at all, they should not go into a subsidiary, but should go right off into a separate institution. In terms of scope, you allow much larger scope to remain in the bank.

Paul Volcker: Yes.

Q58 Lord Turnbull: But in terms of separation, when it happens, it happens in a much more radical way than is being proposed here; we have got a muddle between these two.

Paul Volcker: If I read the Treasury proposal correctly, it would leave a lot more functions with-I am never sure whether the ring fence is around the bank or the other part of the organisation-the main commercial banking part of the organisation. You can list a lot of functions, but the heart of the functions is trading in the broader sense-whether customer trading, market making or pure speculation. The difference between the rule and Dodd-Frank, as it is written, is, again, that the distinction is between the customer relationship and an impersonal relationship. That left market-making in the bank, and speculative trading outside the whole organisation.

Q59 Lord Turnbull: But I think you will find that there are quite a lot of people who agree with your separation. It would be useful if people in this country understood better what these alternative models are. Could I probe a little more this question of subsidiarisation? You are saying that if you have, as in the Vickers model, a company where none of its directors are directors of the group, but the group, on the other hand, is responsible if anything goes wrong, and something goes seriously wrong in the ring-fenced company, people would burn through-to use the words the regulators use-to the group. In the end, this separation will not prove effective.

Paul Volcker: I am not sure-my hearing is not as good as it could be in my old age.

Q60 Lord Turnbull: This second company-company B-that has the more sophisticated products in it, has a separate board with directors, none of whom are directors of the group. The fear, it seems to me, is this: if something goes wrong in there, I think you are saying that it will not be confined there, because it will affect the shareholders of that group. The group directors cannot ignore what the subsidiary directors are doing that is seriously affecting the shareholders.

Paul Volcker: I am certainly saying that. My imagination may be too cribbed or something. You seem to visualise an organisation-a holding company, in our terms-with a board of directors. The board of directors is responsible for the formal operations of the whole enterprise in any ordinary corporation. Then you say you had this one subsidiary that had a separate board of directors, and they are independent. You think you can do this. I do not know what it means to have an independent board that is subsidiary to another board. I guess you can state that in law or something, but still the holding company board will decide how to allocate capital.

You can say that the law says a certain amount of capital has to go to the bank, but nothing is going to stop the holding company from saying, "Well, we will follow the law, but we are going to follow the law just as narrowly as we can." There is nothing in the law that says you have to put more capital in there if you are worried about it, or it is under pressure. Maybe you can put that into law but this is all kind of awkward to me. If they are worried about the other part of the organisation, they are going to think about how they can use the strength of the bank part to support the other part. It is just human nature. I am not saying it is impossible. You can try it.

Q61 The Lord Bishop of Durham: Mr Volcker, in your note to the commission, you said that the internal culture of the dominant international banks has changed radically in recent decades. One of the issues we are struggling with is how much of the bank failures have been due, essentially, to technical misjudgments by well-meaning people, and how much is a cultural failure within the banking world. How would you characterise the changes in culture? You spoke a few moments ago about proprietary trading versus fiduciary responsibilities to customers. You mentioned remuneration or compensation. How would you characterise the culture of change? Is it possible, in your opinion, to put the toothpaste back in the tube?

Paul Volcker: I have been accused of that. I have been around for a while, and I was in banking 60 years ago. One of the things that I remember was being in a big New York bank-one of the biggest banks in the United States. It had $5 billion-worth of deposits, so things have changed, but it was a major international bank for those days. It was anathema in that bank to give individuals bonuses because they thought that this gave the wrong incentive to responsible bank lenders or customer relations people, because they should be working for the bank as a whole and working for the customer, rather than seeking extraordinary rewards for themselves. Now, contrast that with what goes on now, where a tremendous part of the compensation is in not only bonuses, but bonuses that are unimaginably large compared with what they would have been only 20 or 25 years ago-or even 10 years ago. What kind of cultural climate does that create in the organisation? I think it creates quite a different climate.

If I may elaborate a little, people who criticise the so-called Volcker rule might say, "Sure, there were speculative excesses, but that was not the heart of the banking crisis." In fact, a lot of things were the heart of the banking crisis but, just in terms of losses at the banks, it was excessive lending on home mortgages-a traditional business of banks. It went wild. Why did that go wild? I would argue that the compensation practices that crept in, and the very large compensation in the trading parts of banks, infected the culture of the institutions generally, so the lending offices dreamt things up-how to make a lot of money in the short run and get a big bonus. I over-simplify a little bit, but I think it is true.

I guess I can quote him, since he says it openly, but John Reed, who was chairman of Citibank, one of the biggest banks-a trillion-dollar bank, as compared with a $5 billion one-has said something like, "Mea culpa. We put these two different kinds of organisations together and it didn’t work. It’s a cultural problem. It’s not just a fact that you made losses or didn’t make losses on the speculative thing. It created a tension within the bank that was very unhealthy." He is very eloquent about it. I think he is right.

Q62 The Lord Bishop of Durham: To over-simplify, are you saying that a Volcker-rule approach that breaks apart those cultures, plus perhaps compulsory poverty for bankers, might put the toothpaste back in the tube?

Paul Volcker: I think it is entirely practical. You can take out the proprietary trading, and not allow banks to sponsor, with some diminished possibilities, hedge funds or equity funds, because that is basically proprietary trading, too. Three words we have not mentioned are "conflicts of interest", and those activities inherently involve major conflicts of interest. You are not going to avoid all conflicts of interest in banking. You have different customers who compete with each other and different activities that are going to have conflicts of interest, and there are rules to try to moderate them. When you are conducting on the one hand a straight-up trading operation, where you deal with the customer in an impersonal way and do not have a continuing responsibility, and on the other hand you are lending that customer money or not lending them money-whatever you are doing-you get conflicts, or you get conflicts with your investment management business. How can you run an investment management business completely insulated from the trading book you are running on a speculative basis? I guess that my biggest concern is not actually the risks; it is the damage that it does to the culture of the whole institution.

Q63 The Lord Bishop of Durham: That is very helpful. Briefly, because you have answered most of this question, there seems to be a major bank failure somewhere or other every 10 years or so-

Paul Volcker: Yes. Sometimes the same bank.

The Lord Bishop of Durham: Sometimes the same bank. There was Continental Illinois in the early ‘80s, and there was then the Barings failure and so on. Admittedly, that is not always on the scale of 2008, but they are major issues. What is it that makes it so difficult for regulators to foresee what is going to come?

Paul Volcker: It is the hardest thing for a regulator-civil servants who are hard working and very capable, many of them-if things are going well, the economy is thriving and the banks are making money, but you suspect that there are some weaknesses developing. You go to the bank and say, "I don’t think you have enough capital. I think you ought to lay off this activity. You’re getting a little wild." You know what the banker tells you? He says, "I know more about banking than you do. Things are going swimmingly. We haven’t had a loss or a serious loss for four years, and you think you’re going to tell us what to do? I’m going to go to my Congressman and get him to tell the regulator to get off my back because he’s interfering with our legitimate competitive activities which have bothered nobody"-at that point.

The regulator has lots of leverage when things go bad. This is engraved on my mind. Shortly after I became chairman of the Federal Reserve board, I went to Chicago-probably to meet the Reserve bank there and some other people. I had asked to meet the chairmen of two biggest banks in Chicago-that happened to be a special case. At that point, you could not branch-that was how antediluvian it was in Chicago- in the state of Illinois. These were big banks. They were among the biggest commercial lenders in the United States, basically built upon borrowed money, because their basic deposit base could not be that big-a bank could not branch and was all in one city, however big the city. They were pretty top-heavy banks, so I thought, "Well, I am the new chairman of the Federal Reserve and nobody has really talked to these guys." I got them in the room and said, "I think you people are under-capitalised and you ought to raise some more capital.". They, in effect, said, "Who are you? We think we’ve got enough capital. Good-bye.". There was no law or regulation that governed how much capital they had, and one of those banks subsequently went bust.

You have to rely on regulatory discretion a lot, but there is a structural problem here. What I am saying absolutely agrees with Vickers and Liikanen. They are looking for structural changes. They are putting the border line somewhere a little different, but they are worried about the same thing I am worried about. These speculative, trading, impersonal, highly compensated businesses ought to be removed from the basic banking functions. We’re on common ground in that sense; it is just a question of how you do it.

Q64 Lord McFall of Alcluith: Mr Volcker, you are on record after LIBOR as saying that there has been a loss of discipline, and that what is right, natural and ethical has been ignored. That takes us into the field of culture and ethics. Is there a place for culture and ethics in banking, and what it is? Some would say it is like marshmallow-if you put your finger in it, there is nothing of substance there. What do you mean by culture and ethics, and do they go hand in hand?

Paul Volcker: In the case of banking, it is a simple proposition. You have customers, or hope to over a period of time, because it is in your interest to have customers who stay with you and are profitable. The quid pro quo is that you are not going to screw the customer, to put it simply. You are not going to say you are going to sell whatever you want to get rid of just because it is profitable at the moment. That is the distinction I see between the counter-party, where you have none of those theoretical responsibilities, and a relationship.

All the big banks in the United States claim they are interested in relationships. The mail I get from banks advertising their business comes with big headlines like, "The relationship is everything". They put that on the piece of mail that they send to me, but that is not true of their trading operation, when it is, "The relationship is not everything-it is how much profit we can make on this trade today." They have not lost all sense of relationship, but unfortunately they have lost a lot of it.

I knew nothing about it, but after the crisis, I discovered that the SEC in the United States had a rule book that said an investment bank that they were supervising did certain things for which they had a fiduciary relationship and other things that had a counter-party relationship, for which they had no fiduciary responsibility. I do not think that that distinction was much realised in their own approach, but theoretically that distinction has been sitting around in the back of their heads and in the written regulations for a long time. I am not saying anything that is new. Trading operations and impersonal proprietary trading operations are simply different from a continual banking relationship.

Q65 Lord McFall of Alcluith: Do you think that the philosophy of regulation needs to change? My experience is that the regulator is always behind the curve. The experts are in the banks. Indeed, at the time of Northern Rock going down in the United Kingdom, the regulator told us that they put their best staff on to the biggest banks and the less well qualified on to the smaller ones. Northern Rock was a smaller one. When we asked them if they had looked at the business model of Northern Rock, they said that it was none of their business. Is there a need, given all this literature and the complexity of everything, to change the philosophy of regulation?

Paul Volcker: I think that the inability and conflict that you talk about are chronic. You cannot end that; it is part of the world. It is human nature relating to regulatory and political problems. It is why I think it is correct that you want some structural change that is in law and clear enough so that it is not easy to get around. It should be something where the regulator can say, "I’m sorry; I know that you may know more about banking than I do, but I got to enforce the law, because there it is." When it comes to some important points, that is what you want.

You do not want to have just discretionary supervision, because you will lose the argument most of the time. You just do not have much leverage if you do not have some statutory plain English rules, although plain English is a bit of an oxymoron when it comes to our laws. It gets very complicated. There are endless criticisms by banks and others of Dodd-Frank, the Volcker rule and so forth. It is very complicated and very detailed. Why can’t we do something simple? Well, when I read something like Vickers, boy, that is not simple at all. Forty pages describing things in detail in single-spaced type is tough stuff.

To the extent that you can have a clear principle-even though there will be instances when a clear principle does not seem to make sense-if you keep making exceptions all the time, it will not be sufficiently disciplined. The problem begins when things are going well. Anyone can put a lasso around the banks when they are on the brink of bankruptcy; it is when they are doing well that you cannot get them under control. How many people in the United States realised what was going on with the sub-prime mortgage thing? The banks said, "Well, we’re doing God’s work. We’re making mortgages for bad clients. We’re putting people without any credit standing into houses. That is a good American ideal." But, you know, they overdid it a bit.

Q66 Lord McFall of Alcluith: In the accounting field, on present value and accrual, we have seen bankers taking bonuses today on the basis of present value and expected profits. That problem still seems to exist today and is unique to the banking system. What chance have we of that being abolished and accounting rules being squared?

Paul Volcker: A lot of these problems of complexity and discipline arise in accounting. I am no great accountant, but I had previously been Chairman of the International Accounting Standards Committee Foundation. I was aware of something when I realised, after getting down to the detail, how much the problems of the banking regulators are similar to the problems of the accountants when drawing some of those difficult distinctions.

Accountants are in a better position. That does not mean that they are in a perfect position, but somehow they lay down the rules and presumably they are supposed to be followed. There is a lot of controversy about the accounting rules when banks do not like the proposed rules. They brought political pressures to bear both in the United States and on the international board. Compromises are made, sometimes properly and sometimes you wonder about them. We are not talking about anything new.

I shall give you another example-I’ll give too many examples. I talked about bank capital back in 1980 when I became chairman of the Federal Reserve. The United States had no clear capital standard then at all. The biggest bank, Citibank, had a capital ratio of 2% and I think that the big Chicago banks were around that. This sounds crazy, but I assure you that I am reporting it accurately; when I became president of the Federal Reserve Bank of New York, I was visited by the biggest banker in New York, and he said, "I want to tell you that my bank doesn’t need any capital, and I don’t think that we should have any capital." "What do you mean?" "We make a profit every year. If you make a profit every year, you don’t need capital. The only reason I keep any capital is that some fuddy-duddy directors think that it looks better." You would think that he was joking, but he was not entirely joking. He was the same banker who later said that countries don’t go bankrupt, which is part of the reason why he didn’t need capital. Things were going well in those days.

I am losing track of myself. All the Basel stuff-which, frankly, I helped to originate-and the risk-based stuff was done in an effort to get capital standards up and uniform around the world-two desirable objectives that still exist. They are working hard on it. I say, don’t count on the Basel effect entirely because it is subject to all kinds of uncertainties, political pressures and all the rest. There was really no capital at risk originally- so-called risk-based standards: the assumption was that sovereign debt did not have a risk and that mortgages had almost no risk. What were the two things that went bad during the crisis? Mortgages and sovereign debt. They had no risk rating. Has that changed entirely? I don’t think so.

I have lost track of it now, but things are a lot more sophisticated at present. There are hundreds of different weightings for different assets. There is not much of a weighting for sovereign debt, I understand. . Everybody said when the risk-based standards were originally put into effect, "You can’t possibly think that you ought to have the same risk-weighting for some little manufacturing company that you have for General Motors". That didn’t make sense, so they later fixed it up and said General Motors was double A, and did not need much of a capital standard, and so forth. Twenty years later, General Motors goes bankrupt in a way you could not have foreseen when you made up the capital standard. All I am saying is, there you’ve got very able people working very hard, but don’t trust their judgment and ability to administer those capital standards effectively over time. You need to make some arbitrary rules.

Q67 Lord Lawson of Blaby: Everything you have said so far makes a great deal of sense and I agree with it entirely-that does not surprise me, having known you for a very long time. I would like to go back to the question of the structural separation, and the Volcker rule and Vickers ring fence and all that. You make a point, and it seems wholly convincing, that the Vickers ring fence, though well-intentioned, is likely to be permanent. You pointed out reasons why there are difficulties with it-the same name on the door, for example, and the fact that it is those at the top, the same group directors, responsible to the same group of shareholders, because it is a single lot of shareholders from one institution.

Would you say that there is another reason that stems very much from the very first sentence of the note you gave to us, which is extremely helpful, where you refer to the cultural problem and the change in the culture of banking that has arisen? If we are addressing the cultural problem, and I think that we are charged as a Commission to do that-it is, of course, not within the terms of reference of the Vickers committee, so is perhaps the reason why they did not address it, in order that we have to-it is difficult, with the best will in the world, to understand how there could be two completely separate and indeed, totally incompatible cultures within the same organisation.

Paul Volcker: With difficulty, I would say. I do not want to be interpreted as saying that what Vickers or Liikanen are proposing is totally ineffective. They are aimed at exactly the same thing that American law is aimed at, of creating some separation. The core of the thing is trading in both cases. So, the question comes down, I guess, to: did the United States go far enough in concentrating just on so-called proprietary trading? People say that it overlaps with market-making. I think you can make the distinction, but that is a strong argument to use against it. Vickers takes care of that by saying you cannot do either trading or proprietary trading, except in a non-bank part.

Looking at it, I do not know how all these things have come out in Vickers-the law hasn’t been written. The big companies, they can’t deal with the retail bank at all, or under what conditions can they do it? That seems kind of odd to me. The payment system has to be available to everybody. Does that come into the wholesale part, or the retail part? I am interested in the payments system as an individual customer, and big companies are interested in it. Is it a different payment system? I don’t think so. Well, I don’t know-maybe.

Q68 Lord Lawson of Blaby: May I follow that up with two questions that arise directly from that? Accepting your case for saying that the ring fence, although well-intentioned and based on the same fundamental analysis, is not going to do the trick and you must have complete institutional separation, there is the question of where you draw the line. You say, very sensibly, that there is a public function, which should be on one side, and there is proprietary trading on the other. But of course, there is a whole range of activities, largely of a trading nature, which are not strictly speaking proprietary trading, but they would say that it is trading on behalf of corporate customers. However, it still has the same trading culture that you describe.

Paul Volcker: You are right. If you have trading that is not nominally proprietary it can get you in trouble. A trader is a trader. He wants to make money on his customer trading. I think there is a distinction that can be identified. It is a fool’s errand to look at every transaction and say, "That’s proprietary" or "That’s a customer trade" or "That’s a market-making trade". But you can tell over time. It irritates me. Every management, if they have any sense at all, in these big banks maintain very close control over their trading operation. They get reports daily. They know what the positions are daily. They give them orders as to what their value at risk would be and if they keep too much risk they can’t do it, theoretically. They’ve got other controls. They can look at the aging and the inventory and ask why your trading volume is so high and your inventory so low or vice versa.

The key to me in enforcing what was United States law is very simple in concept. You got to have the chief executive officer and the bank’s directors understanding what the law is. There is a difference between proprietary trading and market-making. If you ask a banker whether he knows the difference, they always say yes because they can’t say anything else. They would not be a proper banker if they cannot tell the difference between a proprietary trade and market-making. So they have to say yes. They have to make a rule to control their traders. Is that going to be perfect? No. But a supervisor can look at that rule and see whether he thinks it reasonable. Then what you are going to do, which they will do in the United States, is to have so-called metrics. They will have maybe too many but they will have seven or eight metrics that they will look at. Volatility would be very important. Your ordinary customer trading operation is not going to have a lot of volatility. The aging of the inventory, the size of the inventory, the hedging of the inventory: there are certain things you can look at that are going to give you pretty clear evidence as to whether as a regular matter, proprietary trading is going on and the guys are market-making. It does not mean that you catch every transaction. You don’t have to catch every transaction. I think that can be effective. I have had a lot of traders tell me that.

On that particular point Vickers is clear. They say they are going to take all trading. So what do you do? You say all trading? That means you can’t do any underwriting in the bank itself? They would say, "Well, you put that in the other thing." The logic of the American position goes that the underwriting is clearly a customer-related activity. You are financing the customer; you want to keep the customer; you welcome the choice. Can you make a bank loan or sell a security? You say, "Mr Customer, we’d like to make you a loan, but maybe you want a security. We’ll advise you about that." It is all the same customer to me. That inherently involves some trading, and you end up with that trading relating to the underwriting operation.

Q69 Lord Lawson of Blaby: One of the things you said in relation to an earlier question was that when you found this separation a la Volcker rule and you had this proprietary trading by a separate company, you say that if they fail, let them fail-if they gamble and get it wrong, especially if they get it wrong. Would you not agree that that is actually rather an important issue in its own right? We have been putting too much of the disciplinary burden on the regulatory system and on the supervisors. The more that you can invoke market disciplines, then that reduces the complexity and the difficulty for the regulators and supervisors?

Paul Volcker: This probably the most important single issue in this banking regulation. I do not think there is any daylight between Vickers or Liikanen or Dodd-Frank. Dodd-Frank has got it all and more at this point-whether it is done perfectly or not is another question, but they had eight procedures spelled out as to how to deal with a failing financial institution without "bailing it out". The Government will in effect take it over. They will have enough resources to run it for a while if they deem that it should be run for continuity in the market, but that institution will be liquidated. Liquidated is a strong word. It could be liquidated by selling off parts of it, or selling the whole institution to somebody else.

By its nature, that resolution process will mean that the stockholders are gone and the management is gone and, depending upon what happens, the creditors may be harmed too. That is not, however, what happened during this crisis. We are talking about the United States in particular, but this was true in the UK too. There were a few cases in which stockholders may have lost. There were many cases in which stockholders lost money, but there were not many cases where the stockholders were wiped out and there were not many cases where the management was removed and there were no cases where the creditors lost.

That may be an exaggeration-there may be one or two cases where the creditors lost-but the whole effort in the middle of the panic, so to speak, was to save the institutions and now you have a way to avoid it, but it will not work for a big and complicated international institution if the United States does it alone. What do you do with all the other operations abroad? By far the most important other country is the UK, because these big banks are big in New York and London, but are small in every place else. I am a little casual in saying that, and it is more true of the American banks than the British banks, but there was an interesting statistic that was given to me in looking at the so-called resolution process. It looked at the big American banks and how important the overseas operations outside the United States were and how you measure that. They looked at assets. Some 85% of the assets of these big American banks outside the United States were in London. Only 15% was in the whole of the rest of the world. Some 5% were in Tokyo and no other country had more than 1%. Neither did the country have more than 1% of its own banking system in an American bank organisation.. Japan is not doing all these things anyway. They are kind of behind the curve in all this speculative activity, so that is not such a big problem. The UK, you are probably aware, and the US regulators are working very closely together in my understanding on what they view as a common concern. Liikanen is following this too, so you have the continent of Europe and Britain and the United States working on the same problem, which is inherently an international problem.

Mark Garnier: Mr Volcker, if I may paraphrase what you are describing with the Volcker rule, it strikes me that you are saying that there is one side of the bank that is virtuous by dint of the fact that it equally balances the interests of the shareholders, the staff and the customer, and there is another side of the bank that is non-virtuous, which only balances the interests of the shareholders and the staff and the shareholder is excluded. That is the core behind the Volcker rule.

Paul Volcker: I reject the words "virtuous" and "non-virtuous". It is rather prejudiced. I know one side has a historically important public function. It is hard to see an economy working without commercial banks doing their essential functions. It is not hard to see the economy working without the amount of speculative activity and proprietary activity that has been going on. I am not saying that that is wrong; I am just saying that you should let people do it who are not protected by the Government and who can be permitted to fail because they do not have those protections.

That is what the investment banks were doing. They were immensely profitable, but they got in trouble and they suddenly made themselves into banks, and that is where it got mixed up. Why did they do that? It was because they wanted the Government to support them. At that point, the Government wanted to support them and the only way they could support them was by making them a bank. Now they do not want to give up their banking licence because it is dollars and cents. They are not confident that they can finance themselves economically unless they are a bank.

Q70 Mark Garnier: I am very interested by your whole idea of the cross-contamination of the banking institution from the proprietary traders who have no interest in the outcomes of the customers of the bank, compared with the rest of the bank who should have a vested interest-who do have a vested interest-in the outcome for the customers. I look back to the deregulation of the City in 1986-when you were Chairman. At the time, the London Stock Exchange had two very clear functions. One was that if you took positions on your balance sheet, if you were a market maker, you were never allowed to talk to a customer or an outside investor. If you were a broker who only talked to customers, you were never allowed to take a position on your balance sheet. That to me really epitomised putting the customer at the core of the Stock Exchange by having that rule. Do you think that we lost something quite special when we deregulated the City?

Paul Volcker: You were faced, as we were in the United States, by a whole technological revolution that made it much easier for different types of institutions to deal with each other and for the traditional institutions to engage in these exotic activities. At the same time-this is quite fundamental-you had a philosophical approach that said that markets can take care of themselves. We had a whole blossoming of theorising about the efficiency of markets, the foresight of market participants and rational expectations. Things were going well for a while, so the whole implication was leave it alone; the market can take care of itself. They will have excesses from time to time, but they will control it themselves because it is in their interest to control it themselves. That viewpoint is not very popular any more given what happened. It all went overboard. Specifically, that viewpoint was not consistent with the massive growth of the sub-prime mortgage market. It obviously went well beyond any self-mediating function until it went over the cliff, and then it all collapsed.

You had a whole philosophical development that affected regulators, banks and politicians. It was a different climate. Can we go back to where we were 30 years ago by snapping our fingers or passing a law? No, but we can do things around the edge. It is more than around the edge, effectively the Volcker Rule is more than around the edge, but it is not the whole thing. I get a little irritated by people saying, "Why are you worried about proprietary trading? That didn’t cause all the bankruptcies or failures." It certainly contributed to some of them, as they say, but that is not the point. It is the cultural damage that it does. Where is the corresponding or the offsetting public benefit? There is a public benefit in having reasonably active markets. Good, a lot of people are willing to do that. That was what the investment banks were doing all the time. That is what a lot of the hedge funds are doing. They are not publicly supported. Hedge funds are largely financed by partners. Limited partners may not have much to say, but it is their money that is at stake. They are debt financed too these days, but the heart of their financing is not whether they have a capital ratio of 3% or 10%. It could be 50%, 75% or 40%. It is different. Let them rise or fall on their own.

Q71 Mark Garnier: The Bishop of Durham spoke a bit earlier about pushing the toothpaste back in the tube in terms of standards. Do you think part of the answer could be to introduce more professional standards within the banking industry?

Paul Volcker: It is not just in the banking industry. You had better extend it to the legal profession, too. I don’t want to hurt any feelings here, but we have a real problem. It is getting more attention. What about auditors?

Q72 Chair: As far as I know there aren’t any on the Banking Commission, so you are safe-unlike in the United States, where they would all be lawyers.

Paul Volcker: I don’t want some profession to go away feeling that I did not offend them. There has been a change in professional behaviour: auditors and law firms are an example. That’s part of the compensation question, too.

Q73 Mr Love: This Banking Commission is tasked with looking critically at the whole issue of ring-fencing. I am sorry to come back to that but you are being very diplomatic about the ring fence so far. We have listened carefully to your criticisms. Can we fix the ring fence? More importantly, can we make it more effective than it would be at present?

Paul Volcker: I think if you impose the ring fence right now it will be effective to a considerable extent. I might argue the cause that you did not have to go that far and it makes big business lending more difficult, and there may be questions about the payments system, or it is cumbersome or whatever-that you really did not need to go that far. But, yes, can you make it effective? Compare it to the way we are now.

Q74 Mr Love: You mentioned in comments to The Daily Telegraph that it would not work in foul weather. That is critically important for our discussion.

Paul Volcker: All the time that these problems are very evident you cannot read the Treasury paper, you cannot read Liikanen, you cannot read the original Vickers paper, without knowing that there are leakages, if we can call them that. There are holes in the fence, because they realise there have to be some or that there are advantages in having them. That does not mean it is not going to be effective the day after you impose this. It depends on how many other leakages you put in there. Over time, those are likely to get bigger rather than smaller. That is what happened to Glass-Steagall. We are somewhat influenced by our knowledge of Glass-Steagall.

Glass-Steagall was originally a very simple law. I am simplifying a bit, but it only had a paragraph or two that said a bank can’t trade. With the exception of Government securities and a few other things, you cannot hold a trading security in your account. You can act as a broker for a customer but you can’t deal with it. Then you have a subsidiary and you say, "Why can’t the subsidiary do it?" Somehow the language is put in there, "Well, if it’s not principally engaged, maybe you can do some underwriting." What does principally engaged mean?

For 30 years people assumed that meant, "No, you can’t do it." Then the banks began getting more serious. "What do you mean? The law says ‘principally engaged’. We made up this subsidiary to sell apples and it is principally engaged in the apple market, but we wanted to do some underwriting. That is what the law says." "Oh," we said, in our great wisdom, "with 5% of the activity elsewhere you can do it. That is not principally engaged." But another chairman of the Federal Reserve Board and a few Federal Reserves later, that got to be 25%, 30% or whatever. Through the years a whole lot of additional securities were added to what was possible for a bank and for the subsidiary to own. You could find language in the law that said the regulators had some discretion. There is some justice in those that say by the time Glass-Steagall was abolished it had already been abolished in practice.

Q75 Mr Love: The original Vickers proposal, subsequently slightly amended, was that investment banking would be here and retail banking would be there with a ring fence. I think what you are saying to us is that, over time and with financial innovation, that will change.

Paul Volcker: There are a number of things that they say a retail bank can maybe do for a customer of the wholesale bank. Can a big company put deposits in a retail bank? If not, why not? Maybe they can. I don’t know whether they are out of this, but can the retail bank-I am talking very simple stuff-lend to the big customer and under what terms and conditions? Or is that wholesale? What is the borderline on what is wholesale and what is retail? Endless numbers of these sorts of questions arise. You can read about it. I read it on the plane coming over here.

Q76 Mr Love: Can I move you on and ask you about this whole issue of how independent the retail part of the bank should be? You mentioned the overall board’s wish to allocate capital, which is of course one of the big concerns here. Is there a way of squaring that circle?

Paul Volcker: I think what Vickers says is that the overall board, in the end, can allocate the capital, except he is going to have a provision of law that says that the subsidiary holding company will be responsible for the adequate capital of the retail bank. I think you can agree it is an unusual provision. Maybe it is workable, but I do not know for how long, because they are both part of the same company. The ultimate stockholder has an interest in both sides. It may not be impossible to insulate one part from what, at the end of the day, is in the interest of the stockholder. The immediate stockholder is obviously the holding company, but the ultimate stockholder is the stockholder of the holding company. The law has been changed. He knows what he is buying. Whatever the law says, he does not have influence on the retail bank. That is something that will have to be worked out over time.

Q77 Mr Love: For what it’s worth, some of our larger, significantly important banks seem to be warming to the proposal, although they would like some changes at the boundary. In your experience of the Volcker rule in the United States, where there have been changes to the boundaries, is it possible to be absolutely definitive about those boundaries? What implications does that have for regulation?

Paul Volcker: There are a couple of problems. You may dismiss proprietary trading, but the law says, quite reasonably, that it is not a proprietary position if it is well hedged. I forget the exact language that is used. Now, how do you define that well-hedged position? The banks immediately came in and said, "We hedged the whole position." To make a caricature of it, they said, "We have some stocks. We’ll hedge it against the Standard & Poor’s 500." That is not a hedged trading position. That is a hedge fund. That is what they do. The law says, but you have to be practical about it, if you hold a particular security long position, and you have a short position against that security. That is a hedge, and that is okay. They then say, however, "I know, but we had this particular security, and it is not traded very frequently. We cannot take a short position against that particular security, but we could take a short position against a very similar security or something close to it." So I am sure that, at the end of the day, that is what they are struggling over in writing the regulation. If it is close enough, they will say, "Okay"-as they should-but then how do you define that?

There are problems in the Volcker rule-no question about it-that involve similar problems. The whole credit defaults swaps did not exist 15 years ago. It is a wonderful instrument for hedging. Somehow the banks got along without it for 200 years, but it is a great hedging instrument. It can be an efficient hedging instrument, but that does not explain how at the beginning of the crisis there was an estimated $60 trillion on the value of credit default swaps against a commercial risk that may have been $6 billion to $10 billion. If you hedged every one of them or they were hedged six times over-an oxymoron, someone is hedging hedges. That is what the traders do. That is all right, but don’t do it in the banking system is my argument.

Q78 Mr Love: Let me ask you one final question. It looks likely that the United States is going ahead with the Volcker rule. Europe is considering the Liikanen proposals. We are considering Vickers. Will that cause any problem across the banking systems internationally?

Paul Volcker: You’re getting beyond my competence because I am not involved in writing regulation. I was not directly involved in writing the law and its extra territorial reach, but the law gets a little tricky. Foreign banks cannot do proprietary trading in the United States, but they can do whatever they want to do outside the United States so long as they are not doing proprietary trading with Americans. That is basically what they said. That creates the practical problem of supervision as well as the difficult problem of who is an American and who is not an American.

Some foreign banks told me that a lot of pure foreign trading activity around the world, however it originates, involving foreigners is cleared at the end of the day through New York because that is where the clearing facility is, particularly for dollar transactions. To interpret the law as saying that clearing transactions through the routine New York facility makes it American-I’m exaggerating, but that is an overreach. The law says something like, if it is an American connection you cannot do proprietary trading; you can do ordinary market making. I am sure that the regulator is trying to fix that uncertainty and we hope that a reasonable solution is reached. Can the two approaches work together? Yes, I think they can-not everybody has to be on the same wicket exactly. I come back to the beginning: philosophically, they have common ground. They are both worried about excessive trading, proprietary trading and the cultural implications of that. There is a lot of common ground.

Q79 Mr Love: Maybe we will all end up with an hegemony of the Volcker rule.

Paul Volcker: We can call it the "Love" rule.

Q80 Baroness Kramer: I just wanted to hark back, Mr Volcker, to some of your comments about your long-distant visit to Continental Illinois and First Chicago. To be fair, I should say that I joined Continental Illinois as a new banker on the day that Penn Square Bank in the shopping centre in Oklahoma went bust and took Continental Illinois with it, so I do understand the issue of under-capitalisation and the banks’ difficulty in assessing risk.

Can we dig a little more into your thoughts on Basel III? You have been quoted as discussing the practical difficulties and limitations of setting capital and liquidity requirements. Is it your view that the Basel III approach is just the one approach, and that we should be using a different strategy, or that we should be amending somewhat and adding other features to Basel III?

Paul Volcker: One feature that is very important I guess hasn’t come up. Many of the American regulators feel very strongly about it; continental regulators, at least, do not seem to feel strongly enough. Given the inevitable practical problems in identifying risk and the appropriate capital requirement against different risks, you can think of it probably as back-stop. There ought to be an overall leverage requirement. The risk-based assets are not small, but there are many banking assets that are not covered at all by the risk-based approach. I read about some interesting studies recently that said that, looking backwards, analysing which banks did best during the crisis and which did worst, concluded that the banks with the biggest capital and least leverage-whether or not they conformed to Basel II at that point-did the best, regardless of how that capital was allocated. The United States had no common required standard but they gradually developed the leverage ratio. With much fighting, the leverage ratio was capped in the United States for Basel I and II at quite a low level. I think I can say that in the United States the feeling is, yes, we ought to have a capital ratio and it ought to be higher than they are talking about in Basel-significantly higher-but I do not know whether that will ever be agreed in Basel.

Yes, that may be more important than the risk-based standard. This is the way you get at the fact that some important risks are not covered at all by Basel. The difficulty with it is that which we used to have it that way, the banks said, "OK, we have one capital standard for the whole bank", so "We are not going to buy any government securities any more, because we just want to hold things that are more profitable. We don’t want to allocate 5% capital against government securities". Whatever you do, there are going to be games played. It is inevitable, so you try to make up the rules and somehow anticipate that as best you can. I would strongly say that the risk-based standard ought to be supplemented by an adequate leverage ratio.

Q81 Baroness Kramer: So a leverage ratio to set the floor, then a risk-based mechanism?

Paul Volcker: Yes, except sometimes it may not always be the floor depending upon the risk-based calculation.

Q82 Baroness Kramer: That’s a good point. That chimes in with some of the comments from Andy Haldane about the complexity of capital and liquidity requirements being, in a sense, potentially part of the problem. That is something that tends to lead to gaming as well. Is that a view that you would also take?

Paul Volcker: Yes. The problem with Basel II as I understand it-apart from the obvious grievous omissions of sovereign debt and mortgages-is that they struggled for 10 years to come up with Basel II and when they finally came up with it, we had a big crisis. They were struggling over how do you evaluate risk. Originally, they said, "We’ll look to Standard & Poor’s and Moody’s and so forth". We know how good that was at the end of the day. They said, "We do not entirely want to rely on them", and so they said-this is an outsider’s view-that they would give a lot of weight to banks that had a good internal risk-based system. They said they would see whether they liked this system and if they did, they would rely on the bank system. That sounded perfectly reasonable, but on the other hand, we found out that a lot of banks who thought they had a good system did not and it broke down.

All I am saying is that it is very complicated, so how do you avoid the complications? The complicated things will break down too. So I come back to a very simple thing. A few simple, statutory rules that cannot be changed easily ought to be the backbone of this. The most important one is the resolution procedure. We have that in Dodd-Frank. Most of the people in the market say, "I know, but it won’t work, forget about it." That comes back to being too big to fail. It would be helpful to get a UK-US agreement, because then it is a harder to say it means less. If we can get a simpler one than we have, then all the better. We have common ground on the proprietary trading, hedge funds and equity funds. They are handled differently, but at least there is common ground there. I hope that we get common ground on a leverage ratio.

Q83 Baroness Kramer: Could I ask something about the leverage threshold, just to push a little bit more. You referred to the unfinished reforms of the nature of bank capital and the usefulness of contingent debt instruments. Do you have a comment on that as we think through the leverage ratio issue?

Paul Volcker: I know that is a big issue and it is considered within Europe. For some reason or other this was proposed in the United States back with the Latin American debt crisis in the 1980s-that is how old I am. We had an internal banking crisis following that. So this idea of convertible debt, converting into equity under certain conditions was thrown out at that time. The then chairman of the FDIC was pushing it. The banks never liked it. People in the market tended to say, "It sounds good but it won’t work because nobody will buy the securities." If you get these equity risks in buying debt securities they might as well buy equity in the first place. From the banks’ point of view, they think it is too expensive. So nothing was ever done. It is not a new idea but it is sure on the table again now. I think that ought to be looked at very closely. It would be good to have. It is not an area where you need common ground in every country, but if it is good in Europe, it ought to be good in the United States too.

Q84 Baroness Kramer: Could I ask you almost the contrarian view? One of the issues that we tussle with-I am sure you do as well-is how do you get safer banks on the one hand and yet fuel economic growth on the other. Is there a risk that the general movement towards tighter capital and liquidity standards could choke off lending in economic recovery? I don’t know whether you have some comments on the experience in the US which may be a little different from us in the UK.

Paul Volcker: You hear that all the time in the US. Theoretically it is possible. I do not think we are in the range where that is relevant, frankly. Bank lending involves risks. I guess in my head those risks are socially useful if they are not overdone. You want banks to make loans. You want banks to make loans to small businesses and risky businesses. But you don’t want them to do sub-prime mortgages with no down payment and no credit history and all the rest. So you have to get some kind of a balance.

Q85 John Thurso: Mr Volcker, I want to ask you a little bit about the wholesale markets and banking. You have set out some wonderful insights and you said a moment ago that we just need a few simple rules. The Volcker rule is a simple rule.

Paul Volcker: It sounds simple.

Q86 John Thurso: Why does it need such a vast, complex amount of regulation to enact it?

Paul Volcker: I don’t think it does. I think it requires some regulation and that can be complex. Part of this is parody by opponents. How many times have you heard that the proposed rule a year ago was 300 pages long? It was not 300 pages long. It was 35 pages long and 160 pages of questions that lobbyists had raised about how the rule would work. And they said it wouldn’t work because it was a 300-page rule. I am cheating a little bit. The rule was 35 pages and had an appendix of 30 or 35 pages laying out the so-called metrics that I was talking about which are probably too complex. I hope that they are getting this better. It comes back to the vexing question of principles against rules. There is no doubt that the American legal system and American habits say, "We want a rule, clear and simple, black and white, so we know when we are obeying the rule". They don’t say that they want to know how to get around it, too, but that is part of the deal.

With that attitude, 400 bank lobbyists lobbied the agencies on the regulation: "Spell this out exactly or we won’t like it" or "How do you tell the precise difference in a proprietary deal?" You can short-circuit all that by relying on what I said earlier and by making sure that the general policy is clear and incorporated in the banks’ internal rules. They can write the regulations themselves internally, subject to review. Then you look at the statistics. That should not be a whole new imposition, because they all have daily statistics anyway. They might have to tweak them a bit or add one or two, but it is not that they starting on virgin territory with a whole new reporting burden. They already had the reporting burden inside the bank.

Q87 John Thurso: Thank you. Turning to the whole concept of wholesale banking, you mentioned earlier the figure you have stated before of $60 trillion of CDSs, ergo $6 trillion of actual debt. In the article that I read, you went on to say, "Over the years banks have become much more obsessed with trying to make money by trading between themselves. The amount of ingenuity that is put into complicated structured instruments is just lost energy." Is there any actual or practical common-sense commercial purpose to the instruments that are being traded? Is it necessary at all?

Paul Volcker: A credit default swap is a kind of an insurance policy. You will pay for somebody else to take the credit risk, as you pay fire insurance or anything else. The difference between credit default swap and insurances is that it is against the law actually to take out fire insurance on your neighbour’s property for fear that you may burn it up. Nobody is preventing 10 credit default swaps against the same security. Okay, if you own the loan, XYZ company, and you want to buy the credit default swap, pay a fee and buy it. Okay, that is your insurance policy. That sounds reasonable, right? Insurance, that is what it is. But then the argument is that the person selling that insurance has to have a market for derivatives so that he can hedge his risk. So the lender has sold the policy to you and now have the credit risk. You better lay off some of that credit risk to somebody else. Now we have two derivatives and maybe three derivatives. Exponentially, it rises, but in the end, a lot of it is not anything but speculation. People are taking the risk without the instrument, without the basic loan.

Q88 John Thurso: Does that activity multiply risk in the system rather than spreading it?

Paul Volcker: I think demonstrably it has led at the very least to these greatly feared interconnections. It is certainly a big amount of trading that involves many institutions. You are not playing with just one other institution. You are not just playing with yourself. When the derivative goes bad, God knows how many other people are involved. That is what was feared to happen when Lehman went down. That was cleaned up pretty well in the end, but undoubtedly there are a lot of interconnections.

John Thurso: If we identify "socially useful", a phrase used earlier or the "socially required" side of banking, you have the payment system and you have the deposit collection. You have the loans to small businesses and to proper mortgages to houses. Equally, you have a required commercial side in investment banking, the sourcing of capital for expansion, initial public offerings, mergers and acquisitions, all of which is usual commercial or social-or both-activity. Then it seems that this bubble on the end-

Paul Volcker: That’s why I would leave those in the bank.

Q89 John Thurso: Exactly. There is this bubble at the end where a bunch of guys are selling things that nobody wants or needs, that are not useful and do not contribute to commerce. It is a bit like the horse racing industry here running horses and the bookie industry over there just betting on it and making money. To date we are talking about how we contain and control that, but no one seems to be asking the fundamental question of whether it should happen at all in the first place.

Paul Volcker: I’m a very modest fellow. My imagination does not go that far. There is some function in trading activities, whether it is derivatives or something else, where they buy something and they want to be able to sell it, so you need some traders. The argument you get is that the more liquid that market is-by liquid they mean the ease to sell without any change in price-the better. That is the mark of efficiency. I say yes, up to a point, but liquidity is not an additive good, no matter how much you have, because it may lead to behaviour that is unfortunate in the end. People can buy very complicated risky stuff that they probably should not own in the first place. They’ll buy it and think, "I can sell that tomorrow." That is a very liquid market. It is perhaps too liquid. If they are buying that kind of stuff, maybe that leads to behaviour that needs intervention.

This point is often made with respect to pension funds. Although they are dominant funds with a low perspective, their assets now traded much more actively-the turnover of these institutions is dramatic-and they can do it because stocks and bonds are so easily tradeable. At the end of the day, however, is it really good that these institutions have been churning their position so much? You could have a nice argument about that.

Q90 Mr McFadden: Mr Volcker, going back to this much quoted statistic about your rule being turned into a 300-page rule book, which you mentioned a minute ago, are we to take it from your replies that you think that the integrity of what you proposed is still there, despite all the lobbying by banks to chip away at the edges of it, rather than your taking a view that the integrity has been undermined by making it more complex than it need be?

Paul Volcker: My gut feeling tells me that the initial regulation was more complex than it had to be. I do not know what the final regulation will say. I do not believe that the thrust of it has been chipped away. There is a particular de minimis exception for hedge funds and equity funds, but that is not a make or break thing. The law is pretty precise about what you can do, and the limit of that. They will try to find a way around it. The amount of proprietary trading in American commercial banks is today-I have no measure-without question diminished, because even if the regulation is not fully effective at the moment, they can see it coming.

We are talking about relatively few banks that do this. Don’t forget that. We are talking about five or six banks in the United States. If you want to say eight or ten, I will not fight with you, but it is really only six or seven banks in the United States that do this in big volume. Most banks may occasionally take a flyer, but it is rare.

Some of these big banks-I guess most of them-had a division two years ago to set proprietary trading. Some of them said "proprietary trading" and sometimes they had another title. However, they were proprietary traders. They kept separate from the rest of the bank because the management itself wanted to keep it separate. Those are gone, because they are clearly outlawed by the law by any interpretation. You cannot have a unit of a bank sitting out there doing proprietary trading. Now, the only argument is, "Ok, so the proprietary trader moved three trading desks down on the trading floor and is now called a market maker". Many of those aggressive traders have left, because they could go and trade for somebody else; they could go to a hedge fund. So it has an effectiveness. I think flagrant violation can be detected.

Q91 Mr McFadden: So the glass for you is still at least three-quarters full?

Paul Volcker: Oh yes-at least.

Q92 Mr McFadden: Just going back, the paper that you gave us has a section entitled, "Vickers, Liikanen, Volcker-and the ghost of Glass-Steagall". I just want us to be really clear on your view of this, because to go back to the question that Lord Turnbull asked you, there is some confusion or misunderstanding. You say in this paper that the approaches of Vickers and Liikanen appear close to the former Glass-Steagall restrictions in the US and that since these broke down over time, that may provide a cautionary lesson. Yet hearing you describe your own proposal, to me that sounds more like a Glass-Steagall Two type proposal, because it is proposing a complete separation between two sets of activities, rather than a ring-fence within the same company. So who is closer to Glass-Steagall Two? Is it you, or is it Vickers?

Paul Volcker: They both have elements. I said that because it would allow more functions in the overall organisation than mine would. But you are right. The original design of Glass-Steagall changed over the years. I was going to say that the original design absolutely prohibited trading à la Volcker, but it didn’t. It permitted some trading in the bank itself for certain securities, which got broadened. It did not prohibit so-called dealing effectively in the subsidiary. There were lots of rules in the United States between the bank and its subsidiaries, so that made restrictions on dealing with the subsidiaries-not as strong as Vickers. In that respect, Vickers is attempting to be much stronger than Glass-Steagall. To an extent, the restrictions between the "commercial bank" and the "investment bank" in Glass-Steagall broke down over time. I have a little fear that that might happen in Vickers too.

Q93 Mr McFadden: Can I ask you about one or two other areas as we come towards the end? We are often told-I suspect in the United States and certainly in the UK-that the financial services industry contributes a huge amount to the overall economy and that therefore we should be very careful with doing anything that might spook this industry. But you have also said that a lot of the energy and innovation in recent years has been pretty worthless. There is your famous quote about the only useful innovation in recent decades being the ATM machine.

Paul Volcker: That may have been a little far-reaching.

Q94 Mr McFadden: Do you think that the contribution of financial services to the overall economy has really grown in recent years, or has most of this growth been in terms of its own size and the rewards within it?

Paul Volcker: I am afraid that a lot of it is spinning your own wheels and making money doing it. But there is a calculation-I don’t want to swear by this calculation but I see it-that in American banks in 2008 the losses from trading, not just proprietary trading, were equal in size to all the money they made in trading this century. So they reckon it came out even. It looked very profitable for a while, but when you got in the crisis it all blew up. I didn’t calculate that and I can’t even give you a reference for it, but that point has been made. You can go check what accuracy it has in Britain.

The banks, with this clever financial engineering, can make up all kinds of complex instruments. With the simplest version, they say, "If you give us your money for five years, we will guarantee you against any loss, and if the stock market goes up, we’ll double whatever the stock market goes up by so and so until x happens." You think, "I’m not going to take any loss and I may double my money in the stock market." You kind of forget that-back in those days when you were paid some interest-that if you give them the money for five years, and that is maybe 25% in interest that you are not making.

They are able to offer that deal because they’ve got guys down there-my grandson used to be one of them-who work on their computers and buy options, puts and calls and so forth. They can shape that instrument in such a way that the bank is not ending up with any risk. In fact, with that particular structure of transaction, they are not going to sell it to you unless they are making 2%, 1% or something. You can argue that is a useful service-I am not stopping anybody doing that-but an awful lot of activity of that sort goes on, which I doubt makes a significant contribution to constructive risk taking, economic activity or whatever. A lot of it is pure trading activity. Some of it, I think, is counter-productive, for the reason I suggested. To the extent that the complexities of this led to the breakdown, it is counter-productive for sure.

Q95 Mr McFadden: Following the crisis, there has been, certainly in the UK, a lot of criticism of regulators and the role the regulators played in not blowing the whistle and not, as the phrase goes, taking the punch bowl away at the height of the party. What do you think about the quality of leadership in the banking industry?

Paul Volcker: In the American industry?

Mr McFadden: Leaving aside the regulators, why did so few bankers, if any, speak out themselves against the culture of excessive reward, risk taking, bad incentives and all the rest of it that led to this? What do you think about the quality of leadership in the financial services industry itself?

Paul Volcker: I have to go back to the comments I made earlier. This is part of the whole cultural and intellectual climate of the times. I’m thinking of the amount of money that some traders are making and that some of these executives are making at the top. You often see this statistic. The chairman of a bank, when I was first in banking, might make 50 times or 40 times what the average employee made. Now, he makes 500 times what the average employee makes. It is a difference in scale. They may be smarter than they used to be in the old days. They are certainly more aggressive and they take advantage of the enormous complexity. They get people who understand the complexity and can make money on the complexity. They may end up taking big risks for the economy, but in the short run they are making a lot of money.

I do think that is changing. There is nothing like adversity to change people’s minds. I think bankers have begun to realise that the rules of the game are changing, partly because of regulation but partly because of the losses that were taken and the instability. We see some changes in management. I don’t know what the changes yesterday meant, but it’s interesting to speculate.

Chair: Justin Welby has one more question for you, and then I will ask if you have anything else you would like to add. I think we have kept you quite long enough.

Q96 The Lord Bishop of Durham: Mr Volcker, my question picks up a bit on what Pat McFadden was saying a few minutes ago. Historically, London was restored to its position as a major international financial centre essentially through regulatory and tax arbitrage in the early 1960s, with the opening of the euro dollar market to evade certain issues in the United States. That moved a lot of assets over here. You have commented that roughly 85% of US banks’ overseas assets are in London, and the rest is essentially small change. How much danger do you see of a seismic change similar to the reopening of the euro market if London had strict regulation through regulatory arbitrage of people just upping and moving that 85% somewhere completely different?

Paul Volcker: The argument that you hear all the time is, "Oh, we are all going to move to New York." If you are in New York, you hear, "Oh no, we are all going to move to London." Those are the only two centres now that really have the capability, the size and the knowledge really to do this in a big way. Of course on this side, other centres grow over time. Internationalising some of the basic regulations is what Basel was all about-making a level playing field. It is obviously not ideal that the United States has the Volcker rule and you have Vickers, but I do not think that it is entirely terrible either, because they are both ending up in the same way. We will have a little competition to see which one is better. I would prefer it otherwise, but I do not think that that is the end of the world for British banks or for American banks or for either one, particularly if you can get Europe as a whole to follow suit, as they should. They are not an enormous threat right this minute, but they could become so obviously.

Q97 Chair: By threat, do you mean threat to the financial system?

Paul Volcker: Yes. In terms of a benefit to the economy, sometimes there are characterisations of all kinds of statistics. You can prove whatever you want with statistics. I am going to give you a very uncertain statistic. We have statistics for so-called value-added by industry in the United States; I am sure that you have them here. It is pretty tricky to measure. It is pretty straightforward if you are a manufacturing business, especially if you are an important one. If you look at value-added numbers that were printed in the United States in the decade before the crisis roughly, you will see in the nominal numbers value added in the United States by the finance industry went from five to 10 percent of the total-it may not have been quite that much. If you look at it in real terms, the statisticians did some massaging there and the figures for value added went up very little. So we had all this additional activity and all this additional nominal profit, but somehow the statisticians produced some technique that said there was no real benefit to the economy over what they had before. It is hard to believe. Those calculations for finance are extremely difficult to make, but at least we are in the direction of saying that there is a lot of activity here, but it did not have any striking relationship to real value added for the economy. I can tell you that the automatic teller machine does improve productivity.

Chair: One final question that we have not asked you is whether you think that a lot more could be done by tightening up criminal sanctions for serious wrongdoing?

Paul Volcker: It is frustrating to see this because obviously there has been some wrongdoing. As people say, particularly as time passes, it is very hard to see actual violations of criminal law. You can see a lot of bad behaviour, but do you have a strong case to bring to a jury that beyond reasonable doubt this guy had it in his mind to screw his customer deliberately? It is now easier to bring-we should bring quite a few now-insider trading cases. It is still not easy, but it is the one place where we are seeing people being put in jail.

Q98 Chair: I promised you before we started that I would give you an opportunity to say anything that you hadn’t already. You had a note there right at the beginning of points that you thought you might want to make. I have kept within the two hours that we agreed.

Paul Volcker: Thank you. I appreciate your asking me and that you sit here listening to all these unreasonable propositions. I will end up by saying-I have said it many times-that Vickers, Liikanen, Volcker, and Dodd/Frank are reactions to perceptions of the same problem. I hope that they will all have some effectiveness. Creative and speculative trading is not the only problem. We have problems of capital standard. We have problems of resolution authority. But it is a problem.

Chair: You have given us a great deal of food for thought. We are extremely grateful that you have come today. On behalf of the whole commission, I thank you very much.