Obama Economic Adviser Doubts President's Plan

White House adviser Paul Volcker today criticized the Obama administration's sweeping financial regulatory reform proposals, specifically one that he warned could lead to future bailouts by designating certain firms as "too big to fail."

In testimony prepared for a hearing Thursday morning before the House Financial Services committee, the former Federal Reserve chairman expressed doubts about the administration's proposal to designate certain firms that pose a threat to financial stability, subject them to stricter supervision, and make them submit resolution plans in the event of failure.

"The clear implication of such designation whether officially acknowledged or not will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be 'too big to fail'," Volcker said.

This designation, Volcker said, will only serve to encourage more risk-taking, thereby leading to even worse crises in the future.

"What all this amounts to is an unintended and unanticipated extension of the official 'safety net,' an arrangement designed decades ago to protect the stability of the commercial banking system," Volcker stated. "The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted. Ultimately, the possibility of further crises – even greater crises – will increase."

This approach, he predicted, will adversely affect both the firms that fall into the "too big to fail" category as well as the firms that do not.

"In fair financial weather," Volcker said, "the important institutions will feel competitively hobbled by stricter standards. In times of potential crisis, it would be the institution left out of the "too big to fail" club that will fear disadvantage."

The former Fed chief also expressed opposition to the administration's proposal to remove responsibilities other than monetary policy from the central bank.

"I believe, based on many years experience, that would be a mistake," he argued. "For one thing, enforcing a separation of monetary policy and supervisory policy would not serve either function well. The Federal Reserve Board should not become an academic seminar debating in its marble palace various approaches toward monetary policy without the leavening experience of direct contact with, and responsibility for, the world of finance and the institutions through which monetary policy is affected."

Volcker did not stop there. He went on to criticize another proposal that would form a council of regulatory agencies chaired by the Treasury Department.

"I write with some confidence that a council of variegated agencies with their own particular challenges, policies, and constituencies cannot be expected to efficiently and effectively serve as a coordinating body."

The comments are not the first time Volcker has criticized the administration. In February, he denounced as "shameful" a shortage of staff at the Treasury. On Wednesday, Treasury Secretary Tim Geithner defended the administration's reforms before same House panel.