Practical analysis for investment professionals
25 February 2019

Paul Volcker on Conflicts, Ethics, and the US Banking Industry

In his recent memoir, Keeping At It, Paul Volcker gave me greater perspective on the trials and tribulations of leading the US Federal Reserve and pursuing public policy. That’s hardly a surprise. Few public servants over the last several generations can rival Volcker’s breadth of experience or knowledge. After all, this is the man who stared down the stagflation of the late 1970s and ushered in the so-called Volcker recession. He doubled interest rates to put the squeeze on runaway inflation, thus laying the foundation for the last four decades of price stability — talk about civic duty and toughness!

I have had the good fortune of getting to know Volcker personally over the years. Though it is perhaps more accurate to say he has tolerated my presence and my incessant questions — even as he waited for the bus to work. I greatly respect him.

It is hard to sum up his legacy. For me, he serves as a reminder of our collective duty as finance professionals to ensure that the financial economy is connected to the real economy.

Below is a transcript of one of our talks on the banking industry.

Mike Mayo, CFA: When you look at banks over the last few decades and think about the next few decades, what are the most important considerations?

Paul Volcker: What almost overwhelms me in looking at the world of finance — banking and beyond banking — is how different it is from when I was most active. I’m more than 90 years old and I started out in banks — and at the Federal Reserve at different times — 60 years ago. The whole environment was quite different. You didn’t have an active non-banking financial market. You had investment firms, but you didn’t have large and active hedge funds. Investment banking was a pretty exclusive profession made up of partnerships. I can remember when the law was changed a bit and permitted banks to expand their activities. There was debate in my bank about whether it should expand into those activities or whether that would lead to too many conflicts of interests.

How so?

There was concern by the “old timers” about introducing incentive pay criteria, how that would be the end of “honest banking.” And one must confess that there was something to what they were worried about. You now have this situation with incentive pay dominating corporate and individual decision making. If the top executives are not getting as much pay as their competitors, the directors will worry about it and feel impelled to match the competition to show that they value your work. [It] has gotten all out of context, it seems to me. The amount of pay involved in the banks themselves is worrisome, but it also mirrors what is going on outside the banks.

Look at Goldman Sachs, the great archetypal investment banker. I considered going there once. For better or worse, I didn’t. But, in those days, it was a partnership. I had some very good friends, including John Whitehead and, most of all, [Henry] “Joe” Fowler, who had been secretary of the Treasury. He loved Goldman Sachs. It was a partnership. It was conservative and highly sensitive to culture. It would avoid some kinds of investment banking because they could lead to conflicts. It wouldn’t get involved in an aggressive takeover. That has changed.

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Is it non-bank activities that are bad?

Well, you can’t make a sharp distinction between bank and non-bank activities. Today, banks do stuff that was considered non-bank activities in the old days, and the non-banks are doing some stuff that would be considered bank activities. The non-banks have gotten much bigger relatively, and they don’t have the same regulatory framework. They have a lot more scope. The entire market is so much more complex, it is hard to follow.

You seem concerned.

There have been, increasingly as I sit here at home, increasing concerns about the culture of the financial system, banking in particular. The Holy Grail has been that the only thing that matters is how much profit the firm (and you) make, which Milton Friedman pushed. This is deeply in the interest of the people running these banks and non-banks, and it is losing some of its attractiveness.

I am concerned. What’s the role of directors in keeping culture under control? Can the directors of a big bank really do an effective job of overseeing an institution? Or do they see their job as protecting the chief executive officer who they appointed? Or maybe the chief executive officer appointed them, so there is a certain amount of built-in mutual interest in ducking emphasis on internal controls.

Accounting is immensely complicated and difficult now. It is not clear how individual board members can carry out their jobs responsibly. Not too long ago, one of the big banks had some problems, and a member of the auditing committee had no experience in auditing or financial reporting.

What makes a good banking culture?

The customer comes first. Which is what they all say. How many times do they say, “Your relationship is everything,” until they see a way of making a profit? You try to avoid conflicts of interest. But there’s not much some of these big banks still do that doesn’t involve a conflict of interest. It becomes apparent that you are paying a trader in direct relation to the profitability of their particular transactions. Are they going to worry much about whether that conflicts with another customer of the bank? I don’t think so.

What’s the best way for banks to manage conflicts?

It’s a very difficult story. It becomes more and more difficult when the market is dominated by the few big banks. I’d like to see a lot more thinking about that. If an institution is big enough, it is bound to have conflicts. So how do you chop up the bank so that the differing interests of the customer and bank are separate enough that conflict is reduced?

Let’s talk about the Volcker Rule. Did it create too much bureaucracy for such a simple idea?

You are right. It’s inherent in the process of regulation: Regulation tends to breed more regulation. I tell the story all the time: When I became chair of the Federal Reserve, when the non-bank market was not well developed, the banking market was very different. There was no interstate banking, no big banks by today’s standard.

The Federal Reserve was responsible for a regulation called Truth in Lending. It is a very simple concept. It says that banks must be honest when making a loan. They must explain what the interest rate is and how they calculate it, how frequently it is compounded, what happens when you don’t pay, and so forth and so on. Banks were always [complaining] when I was in New York, “Another damn regulation, unnecessarily complicated, for a simple idea.”

When I went to Washington, I told the staff, “I want a simple Truth in Lending regulation  I want no more than 100 pages.” Staff said, “We can’t do it.” And I said, “Go do it anyway.” Then they finally, reluctantly, came up with a 100-page regulation and put it out for comment. Who do you think all the comments were from? The bankers. “You didn’t take care of the particular way that we advertise or whatever and we want another provision in there.”

So, it grew beyond 100 pages because the banks themselves were proposing the regulation.

Now you get something like the Volcker Rule. The traders say, “I want real freedom. I don’t want to worry about what is a proprietary trade — my idea is making money for the bank and for me, regardless of communicated intent. It is too complex.” So they talk to the regulators, and the regulators try to make very detailed rules about what is and what isn’t [ . . . ] I think you can do it a lot more simply than that. But to do that, the banks have to trust the regulator and the regulator needs to trust the bank. They are both trying to fairly qualify what is a pretty simple idea: Are you operating for yourself, or are you operating for a customer?

I heard complaints from banks: “We know our customers want to buy securities. So we stock up on securities knowing that they will buy them later.” To them it is heroic trading. To me it sounds like front running. The banks have gotten rid of their separate proprietary trading units. That was relatively small but a vital signal.

When you look at non-bank and bank activities, to some degree don’t they help service the customer better?

Well, I don’t know because these non-bank hedge funds, they’re not worried about servicing the customer. They are worried about how can they leverage what they just bought, maximize profits, and sell it at a higher price. They’re not guardians of truth and valor ordinarily. It’s the contrary. Banks have to compete with that.

 You once said that the only real innovation in banking over the last few decades has been the ATM. Can you add anything that’s positive?

[Laughing] I was being sarcastic.

A lot of the trading and a lot of the derivatives — which I don’t understand well at all — is trading for the sake of trading. It ended up with exposures at the banks that the regulators didn’t realize they had. The theory was that if the activity is going on outside of the banks, it is much safer for the banks. I was a believer in that theory, and I’m still a believer to some extent. When the non-banks get that important, you have to worry about them, too.

What makes a good banker?

The honest, cautious man or woman. Do they have a fiduciary responsibility or not? And, I believe that they do have a fiduciary responsibility. The accounting world is in real trouble, too, with pressures to serve the client and not the profession.

I saw a column, a news report, a few months ago. Some investment firm had a customer that was doing an M&A, and a different part of the firm that knew the transaction was under consideration was buying or selling the stock. Apparently somebody complained and the firm lost a court case. On appeal, the lawyer for the firm said, “There is no problem here because there is no fiduciary responsibility. The customer was an adult and knew to take precautions, and there was no fiduciary responsibility among informed participants.”

Complete that thought. So there’s a difference between fiduciary legal responsibility and fiduciary moral responsibility?

I think there is a legal responsibility. What struck me is what the lawyers were arguing. They were saying that you couldn’t have a conflict of interest between knowing adults. It seems to me not a foundation on which to build the financial markets.

I run into this situation with my analysis of big banks. When I look at legal precedent, the banks may not be criminally guilty. But from a moral perspective, sometimes they should have done more. How do I reconcile those thoughts?

This is why regulation gets so detailed. As you get regulation, you try to find ways around it. And then you have more regulation.

Is it better to have simpler regulation?

No, because the bankers will exploit it if the regulator does not have the authority and confidence to enforce the rules ex post. You don’t have to get rid of every proprietary trade — you see it ex post. If you see a bank doing proprietary trading and it is no secret (you look closely enough), you tell them to stop.

What about when you see something wrong?

We didn’t mention the enormous lobbying weight put on regulation — millions and millions and millions of dollars going into political contributions. That influences the congressional attitude toward the regulators. The regulators need a lot of authority and support.

What’s the purpose of the financial markets?

To link up lenders and borrowers to meet their financial needs and to serve their objectives legally and morally, thereby contributing to growth and stability.

What roles do Wall Street and the financial markets have in helping Main Street? How much more economic growth is created by more effective and efficient financial markets?

You are guarding against the crises and the depressions. A lot of economic growth might be supported by a wild bout of investment activity that might not be soundly based. But that would be counterproductive.

You raise many concerns. Through CFA Institute, there are over 150,000 financial analysts who believe in putting ethics first. They are in the trenches holding institutions, management, and others accountable and practicing finance in ways that help the real economy. That’s the objective. So what would you tell this global army of on-the-ground watchdogs?

Keep at it.

Paul Volcker continues to demonstrate his commitment to public service and the public good through his work with The Volcker Alliance and his associations with the World Justice Project and the Systemic Risk Council (SRC).

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image courtesy of the US Federal Reserve


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About the Author(s)
Mike Mayo, CFA

Mike Mayo, CFA, has spent 30 years as a bank analyst and is currently at Wells Fargo Securities. He is the author of Exile on Wall Street and a regular speaker and contributor to CNBC, Bloomberg, and other media. Among other accolades, he received the Daniel J. Forrestal III Leadership Award for Professional Ethics and Standards of Investment Practice from CFA Institute in 2013, and CNN/Fortune named him one of eight individuals to call the financial crisis.

3 thoughts on “Paul Volcker on Conflicts, Ethics, and the US Banking Industry”

  1. Your current employer would benefit from reading your interview.
    Paul Volcker has been a role model for good stewardship for decades. Thank you for sharing his thoughts.

  2. Chris Merker says:

    Thanks for this article. The moral sentiments and grand legacy embodied in Paul Volcker makes him a living legend, and a credit to the profession. Having taught and written on governance and investment ethics for the past 10 years at Marquette University in my Sustainable Finance course (and worked for one of the last partnership investment banks left in the industry) where my students and I have discussed and examined the 2008 financial crisis, among others, I have to politely disagree with his position shared by most regulators that the answer is always more regulation. He himself acknowledges the problem in the article of more and more regulation is in effect “no limit tail chasing”.

    The fundamental problem is the problem of agency, and misalignment with shareholders, which adversely affects clients. Fix the incentives and you address the client “in the crossfire”. The way to do that is to separate investment banking from commercial and retail banking (re-enact Glass-Steagal) , and ban investment banks (and hedge funds) from becoming public companies (mandatory reintroduction of the partnership model). Investment banks are in the business of risk taking and as such must be managed as owners not hired hands. They are inherently different from Main Street banks and companies and must be treated as such. Ad infinitum of rules and regs over the last century is proof of this difference, but must be addressed at the core, not on the piecemeal margins, which has been our current state since the first investment bank went public in the late 1970s.

  3. Kirk Cornwell says:

    Here is a man who knew the purpose and the limits of the Federal Reserve. Now we are in the hands of a look-alike crew who seem to think they are doing us a favor with planned 2% annual erosion of the value of our money. It will be interesting to see if we can remain the best house on a bad block of fiat money printers. Things are different now (?), maybe.

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