Former Federal Reserve Chairman Paul Volcker said Thursday that by designating some companies as critical to the broader financial system, the plans create an expectation that those firms enjoy government backing in tough times. That implies those financial companies "will be sheltered by access to a federal safety net," he said.
Lawmakers should make clear that nonbank companies will not be saved with federal money, he said.
Emergency measures by the Fed, Treasury and Congress during last year's financial crisis created the expectation that the government would step in to protect failing companies, their bond holders and stockholders, Volcker told the House Financial Services Committee.
Volcker said he does not differ with the administration on most of its proposals, and takes "as a given" that banks will be bailed out in times of crisis.
But he opposed bailouts of insurance firms like American International Group Inc., automakers' finance arms and others.
"The safety net has been extended outside the banking system," Volcker said. "That's what I want to change." He said the administration's proposal to create a new system for winding down large nonbank companies would make that easier.
The administration should make it clearer that a "safety net" will apply only to traditional banks, not investment companies or others. Investors must understand that if a nonbank company fails, stockholders and bondholders' money would be at risk, he added, while endorsing other options for these companies, including forced mergers or liquidation.
Volcker, 81, has emerged as one of the administration's internal critics. He serves as head of President Barack Obama's Economic Recovery Advisory Board, but has said the administration should take a slower, more methodical approach to overhauling the financial system.
Volcker served as Fed chairman from 1979 to 1987, when he tamed raging inflation, though at the cost of painful interest rate hikes that triggered a recession.
In recent speeches, he has expressed little enthusiasm for some of the initiatives under discussion in Washington, including regulating bankers' compensation. He has said there is "ample justification" for public anger at pay practices that were "wildly excessive" and encouraged risk-taking at the expense of stability. But he warned against too much political involvement.
In his remarks Thursday, Volcker endorsed a stricter separation between banks that hold deposits and investment banks. He said the "safety net" should be limited clearly to commercial banks, while investment banks should be excluded.
"Commercial banks are the indispensable backbone of the financial system," Volcker said, giving consumers safe deposit accounts and financial advice.
Investment banks take on more risk and face conflicts of interest when they combine consumer financial services with major corporate dealmaking. Volcker said it would be logical to prohibit commercial banks from trading in securities and derivatives.
The House committee is leading the effort to pass Obama's financial overhaul. Its chairman, Barney Frank, D-Mass., on Wednesday agreed to scale down a key pillar of the financial overhaul: A new regulator to protect consumers from unsafe financial products and activities.
Treasury Secretary Timothy Geithner endorsed the less ambitious plans, which would exempt retailers and other nonbank companies from oversight.
Referring to the meeting of global leaders kicking off Thursday in Pittsburgh, Volcker said, "A lot of what needs to be done really does require a certain consistency internationally, because these problems are global."
Leaders including Obama are expected to take up global financial regulation at the meeting.
Volcker also said he hoped the administration would work to create a national charter for large insurance companies. That would help prevent failures like AIG's, where too many regulators oversaw different pieces of the company.
The White House decided not to take on that issue as part of this year's financial overhaul. Frank said the issue is on the agenda for next year.
Frank and Senate Banking Committee Chairman Christopher Dodd, D-Conn., say they will have a bill on financial regulation ready for the president's signature by the end of the year.
Volcker said he supported the administration proposal to create a council to oversee systemwide risk, "so long as there's someone who's guiding the process."
The administration has proposed that the Fed have ultimate authority over those issues, but would have Treasury chair the council.
Volcker said that power should rest with the Fed. He also supports a proposal to create a new position at the central bank, appointed by the president and responsible for financial oversight.
Former Securities and Exchange Commission Chairman Arthur Levitt said the ability to wind down big companies is more important than who oversees risk.
"It does not matter who serves as the cop on the beat if there are no courts of law to send lawbreakers to jail," Levitt said in prepared remarks.
It's critical that lawmakers respond to the recent financial crisis with "important action," Volcker said. "Memories grow dim, and you want to make a system where you don't have a still bigger crisis 10 years from now."