Financial Reform, Innovative Hedging and the Volcker Rule

Abstract

Volcker Rule suggests a break-up of 'too big to fail' financial institutions to prevent future costly bailouts and great recessions. We need to (i) regulate derivative trading to make it more transparent, (ii) fix conflicts of interest in ratings agencies, (iii) ban shadow-banking and off-balance sheet entities (iv) limit bank leverage, and (v) reform compensation practices. Since Enron-type scandals revealed that the so-called 'Chinese wall' self regulation was failing, Vinod (2002b) called for more workable reforms including divestiture of very large institutions. This short paper considers the role of financial innovation, hedging strategies, and systemic risks for the world economy. I argue that conflicts of interest are better handled by a break up. A divestiture of derivative ‘market making’ from the rest of Goldman Sachs is suggested.

Keywords: Enron, Goldman Sachs, Conflicts of Interest, Divestiture

JEL Classification: G34, G28, D21, D43, F36, M41