UPDATE 1-Volcker sees markets more fragile without reforms

Sun Jan 31, 2010 4:50pm EST

(Adds Volcker comments, details from bailout report)

WASHINGTON Jan 31 (Reuters) - Failure to enact financial reforms to curb large banks' risky activities and allow them to fail without broad market disruptions will make the financial system even more fragile in the future, Obama administration adviser Paul Volcker said on Sunday.

In an opinion piece written for The New York Times, Volcker, a former Federal Reserve chairman, said the United States needs better protection against "outliers" -- a limited number of mega-institutions whose failure would be "disturbing" to markets.

"The implication is clear. We need to face up to needed structural changes, and place them into law," Volcker wrote. "To do less will simply mean ultimate failure -- failure to accept responsibility for learning from the lessons of the past and anticipating the needs of the future."

Volcker wrote that during his 60-year career as a banker, regulator and central banker, he has seen "memories dim" after crises, and noted that there will be pressures to "lay off" tough regulatory changes.

In the most recent crisis, bailout efforts that saved several large institutions from collapse left a "residue of moral hazard," Volcker wrote, implying that "really large, complex and highly interconnected financial institutions can count on public support at critical times."

The bailouts have given these firms a competitive advantage in their financing, in their size and in their ability to take and absorb risks.

"As things stand, the consequence will be to enhance incentives to risk-taking and leverage, with the implication of an even more fragile financial system. We need to find more effective fail-safe arrangements."

A government auditor for the U.S. Treasury's $700 billion bailout program also found that the bank rescues have made reckless behavior more likely. A new report released on Sunday by the special inspector general for the Troubled Asset Relief Program said the bailouts have cemented a "heads I win, tails the government will bail me out mentality" among investors in banks that have feasted on taxpayer funds.

CURBS WON'T HURT INNOVATION

Volcker wrote that the Obama administration's proposal to prohibit depository banks from owning or sponsoring hedge funds, private equity funds and proprietary trading would not harm financial innovation as some critics have complained. There are currently only about four or five American "mega-commercial banks" and about 25 or 30 internationally that practice the three risky but lucrative activities, he said.

"The further point is that the three activities at issue -- which in themselves are legitimate and useful parts of our capital markets -- are in no way dependent on commercial banks' ownership," Volcker wrote. "These days there are literally thousands of independent hedge funds and equity funds of widely varying size perfectly capable of maintaining innovative competitive markets."

Volcker also put in plugs for other Obama administration reform proposals, including setting up a resolution authorities to step in and liquidate or merge a systemically critical company that is on the brink of failure. This should be coupled with a "living will" that makes it clear that stockholders and management stand to lose if the company fails.

He added that it was essential that the United States work with other nations with big financial markets to reach a broad consensus on reforms. "My clear sense is that relevant international and foreign authorities are prepared to engage in that effort," he said. (Reporting by David Lawder, editing by Martin Golan and Bernard Orr)

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