MCHENRY: In essence, the E.U. is going a different direction when it comes to sovereign debt than we are in the United States. How would you react to that?
YELLEN: I believe the exemption for U.S. debt markets was built into Dodd-Frank. That was explicit in Dodd-Frank.
MCHENRY: OK. So but -- what is your reaction to that? We're policymakers. We could remedy that if you think that, that is a flaw.
YELLEN: You know, we have tried to write a rule that is consistent with Dodd-Frank as it was legislated.
MCHENRY: So if we -- would you look favorably upon us saying that sovereign debt should not be exempt or should comparable to corporate debt?
YELLEN: That's something I would have to look at more carefully. I...
MCHENRY: But did you not look more carefully at this subject matter when you wrote the Volcker rule?
YELLEN: Well, we -- we put into effect the allowance that Congress included in Dodd-Frank to exempt treasury securities.
MCHENRY: Yeah -- well, no, that's treasury securities. I'm asking about sovereign debt, which was excluded from the Volcker rule. Written into the language of Dodd-Frank is exclusion of U.S. sovereign debt, not the exclusion of other sovereign debt.
I would call this a lack of enthusiasm from you.

GARRETT: What progress are you making on actually completing and complying with this -- more than the spirit of cost-benefit analysis and rulemaking?
YELLEN: Well, the Federal Reserve strongly supports analyzing the cost and benefits of rules that it puts into effect, and we've done a great deal of that. An example I could give you is in connection with our Basel capital rulemaking where we participated in extensive cost-benefit analysis hopefully with other regulators.
GARRETT: Would you say you're satisfied with how it came out with Volcker?
Because we had no indication that a cost-benefit analysis was done. And I asked Governor Tarullo who was here where it is, because we have not seen it. So two years later, it seems like on something that's important as that, it was not done.
Do you believe it was done in that situation?
YELLEN: Well, I think -- I think what's important in the case of Volcker is that Dodd-Frank required the Federal Reserve -- in essence the decision about the cost and benefits of putting those restrictions in place were decided by Congress, taking account of what the likely cost and benefit would be.
And our job has been to implement it. We have certainly taken into account, issued a proposed rule, received a wide range...
GARRETT: Right.
YELLEN: ... thousands and thousands of comments.
GARRETT: I appreciate that. My time is very limited. And so I would encourage that a true cost-benefit analysis, one where I could actually say please submit to -- for the record, that it be submitted to Congress, which, I think in anyone's estimation, was not done fully in Volcker.
Speaking of Governor Tarullo, you know, the president has not appointed anyone to fill the position of supervisory division vice chair.
YELLEN: Vice chair.
GARRETT: Would you say that Governor Tarullo is effectively holding that position until that is completed, until the appointment is made?
YELLEN: Well, we operate at the board through a committee system.
GARRETT: Yes.
YELLEN: I usually have three governors and a chair. And Governor Tarullo heads the board's banking supervision committee.
GARRETT: So...
YELLEN: In that sense, he certainly takes the lead.
GARRETT: ... takes that role.
So would you...
YELLEN: But all of us are involved and all of us are responsible.
GARRETT: But in light of your comment, would you commit, then, to have the -- Governor Tarullo come and testify on federal rulemaking before this committee, since he seems to be filling that role until the president makes the...?
YELLEN: He has done a great deal of testifying on these topics.
GARRETT: Just on that topic, we can ask him?
YELLEN: On all topics.
(CROSSTALK)
GARRETT: I understand. I guess I'm asking for a commitment that we can have him come back in that role and testify before the committee on rulemaking.
YELLEN: Well, you know, I don't want to commit as to what he's going to do, but he has certainly taken the lead role in testifying on these topics.

Proponents of breaking up firms by business line may reply that the next financial crisis will not likely have the same genesis as the last, and that separating commercial from investment banking could at least mitigate the risks of extending the safety net provided depository institutions to underwriting, trading, and other activities of very large firms. But an industrial organization perspective suggests that the proposal could entail substantial costs. The reinstatement of Glass-Steagall would mean that bank clients could no longer retain one financial firm that would have the capacity to offer the whole range of financing options--from lines of credit to public equity offerings--depending on a client's needs and market conditions. Moreover, many banks that are far too small ever to be considered too big to fail do provide some capital market services to their clients--often smaller businesses--a convenience and possible cost savings that would be lost under Glass-Steagall prohibitions.

I view proprietary trading as an activity of low or no real economic value that should not be part of any banking model that has an implicit government backstop.

First and foremost, it is traditional banking of the sort engaged in by community banks that promotes true liquidity in regions and within sectors, through deposit-taking and lending. Sure, liquidity in opaque financial markets may have increased in recent years by virtue of proprietary trading, but how has this market liquidity benefited consumers, retail investors, small business owners, and homeowners? Second, the Volcker Rule does not prohibit proprietary trading by all entities. Rather, it focuses solely on government-backstopped banks and their affiliates. Thus, even if federally insured banks are precluded from making markets, these markets can continue to be supported by conventional investment banks, hedge funds, and other financial market participants. Thus, any supposed impact by the Volcker Rule on overall market liquidity or credit spreads is, to me, questionable.

Moreover, much of this so-called liquidity, especially in opaque over-the-counter markets, is potentially illusory and destabilizing, especially during adverse market conditions, which does not benefit the public. Indeed, proprietary trading involves buying and selling purely for speculative purposes that have little to do with a true assessment of a financial position's underlying value. Price discovery actually is impeded by this hyper-liquidity that is introduced by such speculation. This hyper-liquidity, motivated by nothing more than expectations of short-term price movements, creates inefficient subsidies to buyers and sellers with no compelling public benefit.

I think that certain markets should feature large credit spreads because they involve truly risky products. Thus, a reduction in proprietary trading may have the effect of increasing spreads, but that is actually a public benefit, not a cost, because those wider spreads will more accurately reflect the risk involved in those positions.

All of this is to say that liquidity is not an inherent public benefit that justifies the expenditure of significant compliance, oversight, examination, and enforcement costs. In other words, certain capital market activities for federally insured banks should not be supported by vast amounts of public and private expenditure.

"If a firm said, 'We're doing this because it's a hedge,' they would be required to explain to themselves, importantly, as well as to the primary supervisor, what the hedging strategy was, how it was reasonably correlated with the positions that they were hedging, and how they would make sure that they didn't give rise to new kinds of exposures," Mr. Tarullo said.

J.P. Morgan would have to provide regulators with documentation showing this, he added.

U.S. regulators will need to carefully consider the concerns that have been raised and the broader international implications of the Volcker Rule as we work to finalize our implementing rules.

One of the more difficult tasks in implementing the statutory prohibitions is distinguishing between prohibited proprietary trading activities and permissible market-making activities. This distinction is important because of the key role that market makers play in facilitating liquid markets in securities, derivatives, and other assets.

Banking organizations that have access to the safety net should be restricted to the core activities of making loans and taking deposits and to other activities that do not significantly impede the market, bank management and bank supervisors in assessing, monitoring and controlling bank risk-taking. However, these actions alone would provide limited benefits if the newly restricted activities migrate to shadow banks without that sector also being reformed. Thus, we also will need to affect behavior within the shadow banking system through reforms of money market funds and the repo market.

"We really do need to think about redefining the scope of legitimate financial activities of the commercial banks,” Hoenig said, voicing a previously stated view. “That means to break them up, in essence."

Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place. We must make the largest institutions more manageable, more competitive, and more accountable. We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis.

[B]ecause of the specific language contained in the [Dodd-Frank] act, this exemption for traditional bank derivatives activities does not apply to foreign banking firms that have access to the Federal Reserve's discount window through their U.S. branches. A possibly unintended effect of the act's push-out provision may be to require some foreign firms to reorganize their existing U.S. derivatives activities to a greater extent than U.S. firms.

In the period leading up to this most recent crisis, the regulatory authorities, like the industry, trusted that the market would self-regulate. It didn’t, it can’t and it won’t. The industry's structure and incentives are now inconsistent with the market being the disciplinarian.

The Volcker Rule does not reinstitute Glass-Steagall. It does improve the odds toward financial stability by instituting a partial return to the separation of commercial and investment banking activities. It strives to affirm the principle that those institutions that by their franchise have access to the safety net should be separated from those firms that are free to speculate with shareholder, not taxpayer, funds.

Paul has it right.

....

As a Swiss central banker once insisted to me many years ago, “ [I]t is the central bank's job to focus on the long run so that the short run can take care of itself.”  For me, one certain lesson from this most recent crisis is that both the industry and supervisory authorities lost sight of the long run.

[T]here are aspects of the Dodd-Frank Act that are unlikely to become part of the international financial regulatory framework. For example, the act generally prohibits U.S. banking firms (and the U.S. operations of foreign banking firms) from engaging in proprietary trading and from investing in or sponsoring private investment funds. The act also prohibits U.S. depository institutions from entering into certain types of derivatives transactions. In the United States, activity restrictions have long been a part of the bank regulatory regime, serving to constrain risk-taking by banking firms, prevent the spread of the market distortions caused by the federal bank safety net to other parts of the economy, and mitigate potential conflicts of interest generated by the combination of banking and certain other businesses within a single firm. Many other countries follow a universal banking model and are unlikely to adopt the sorts of activity restrictions contained in the act.

[T]here are many times in which a bank has to do something that looks like proprietary trading for good reasons, for example, to hedge its position. If it's got loans, then it may need to buy various derivatives to hedge those loans. If it is running a fund of some kind, then in order to attract customers it may have to take a share of that fund. And so on and so on. So there are lots of ways in which a bank may need to have - be exposed to a position in order to serve its customers.

I think Chairman Volcker would agree that there are those circumstances like hedging, for example, where you don't want to prevent banks from buying the assets because that actually makes it more risky, not less risky. 

So the way I've looked at this is that - and the way the Senate bill, as I understand it, would work is that it create this separation between proprietary and non-proprietary trading, but it would ask the regulators, including the Federal Reserve, to figure out what the line means. And in particular, when is the purchase of a derivative or some other security legitimate hedging, legitimate customer service and when is it gambling with the bank's capital, ultimately the taxpayer's backstop?  So as long as there's a reasonable process for distinguishing between those two categories of assets, I think that can be made to work and as one of the regulators, we'll certainly work with our colleagues to try to make it operational.

Winston Churchill said that “in finance, everything that is agreeable is unsound and everything that is sound is disagreeable.” I think the disagreeable but sound thing to do regarding institutions that are TBTF is to dismantle them over time into institutions that can be prudently managed and regulated across borders. And this should be done before the next financial crisis, because we now know it surely cannot be done in the middle of a crisis.