by Calculated Risk on 9/23/2009 11:10:00 PM

Former Fed Chairman Paul Volcker testifies in front of the House Financial Services Committee at 9 AM ET on Thursday about financial reform.

For those interested, here is the webcast.

Here is his prepared statement. A few excerpts:

However well justified in terms of dealing with the extreme threats to the financial system in the midst of crisis, the emergency actions of the Federal Reserve, the Treasury, and ultimately the Congress to protect the viability of particular institutions – their bond holders and to some extent even their stockholders – have inevitably left an indelible mark on attitudes and behavior patterns of market participants.

• Will not the pattern of protection for the largest banks and their holding companies tend to encourage greater risk-taking, including active participation in volatile capital markets, especially when compensation practices so greatly reward short-term success?

• Are community or regional banks to be deemed “too small to save”, raising questions of competitive viability?

• Does not the extension of support to non-banks, and even to affiliates of commercial firms, undercut the banking/commerce divide, ultimately weakening the commercial banking system?

• Will not investors in money market mutual funds find reassurance in the fact that when push came to shove, the Treasury with an extreme interpretation of its authority, took action to preserve those funds ability to meet their declared commitment to pay their investors at par upon demand?

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. 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.

There is no easy answer, no one-size fits all contingencies. Experience, not only here but in every country with highly developed, inter-connected financial systems and institutions bears out one point. Governments are not willing to withhold financial and other support for failing institutions when there is a clear threat to the intertwined fabric of the financial system. What can be done is to put in place arrangements to minimize the extent of emergency intervention and to damp expectations of government “bailouts”.

Volcker goes on to disagree with the Treasury plan to name banks that are “systemically important” or "too big to fail".

Think of the practical difficulties of such designation. Can we really anticipate which institutions will be systemically significant amid the uncertainties in future crises and the complex inter-relationships of markets? Was Long Term Capital Management, a hedge fund, systemically significant in 1998? Was Bear Stearns, but not Lehman? How about General Electric’s huge financial affiliate, or the large affiliates of other substantial commercial firms? What about foreign institutions operating in the United States?

All hard questions. In practice the “border problem” seems intractable. In fair financial weather, 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.

Volcker argues for a more traditional approach that sounds like the return of Glass-Steagall.