US bank-backed private equity arms have to ‘stand alone’

Former Federal Reserve chairman Paul Volcker has warned US banks to choose between running private equity and private equity real estate operations and taking deposits.

Appearing before the Senate Banking Committee, Volcker defended US government proposals to restrict banks from owning, sponsoring and investing in hedge and private equity funds saying such operations should live or die by their activities – without the unfair advantage of taxpayer support.

They are, and should be, free to trade, to innovate, to invest – and to fail. [They should be] able to profit handsomely or fail entirely as appropriate in a free enterprise system. Former Federal Reserve chairman Paul Volcker on bank-sponsored private equity funds

He stressed in his testimony today that commercial banks were covered by federal deposit insurance, access to the Fed's discount window for emergency loans and the knowledge that some firms were simply “too big to fail”.

However, Volcker insisted if bank holding companies wanted to invest in riskier activities, such as private equity and private equity real estate funds, such operations should “stand alone”.

“They are, and should be, free to trade, to innovate, to invest – and to fail,” he said. “[They should be] able to profit handsomely or fail entirely as appropriate in a free enterprise system.”

As such the US government is urging urged lawmakers to back its call – dubbed the Volcker Rule – for bank holding companies to choose between taking deposits and being a “financial company that can do other activities”.

Volcker though came under fire from Republican committee members during the committee meeting today, when they questioned whether the new proposals would have prevented the financial crisis in the first place.

I may not live long enough to see the [next] crisis, but my soul is going to come back and haunt you. Volcker urging lawmakers to take action against speculative trading

Senator Richard Shelby – the banking committee’s top Republican – said the new rules wouldn’t have applied to investment banks Lehman Brothers and Bear Stearns, both of which sponsored private equity and private equity real estate funds and failed during the crisis. Lehman and Bear Stearns were seen as the catalysts of the credit crisis, yet Shelby said such institutions would not be affected by the Volcker Rule.

Responding to one challenge, Volcker told the lawmakers that if speculative activity was allowed to continue at its current pace, “I may not live long enough to see the [next] crisis, but my soul is going to come back and haunt you”.

The former Fed chairman, who chairs a presidential advisory board, was also challenged on whether the US could lose out to competitor countries if the proposals were enforced. Volcker said the US hoped the UK and other European countries would adopt similar restrictions.

However, banking committee chairman Senator Chris Dodd said he supported the proposals, which in his mind “make sense”. He cautioned though that questions remained over how the policies could work in practice.