By DAMIAN PALETTA and JOHN R. EMSHWILLER
LOS ANGELES -- Former Federal Reserve Chairman Paul Volcker on Wednesday said banks should operate in a much less risky fashion, including not making trading bets with their own capital, comments that could provoke intensified debates over the future of financial regulation.
Mr. Volcker, who currently is chairman of the White House's Economic Recovery Advisory Board, suggested banks should be restricted to trading on their client's behalf instead of making bets with their own money through internal units that often act like hedge funds.
Mr. Volcker's comments could put him at odds with the Obama administration's proposal for new financial rules. The White House has called for more oversight of banks' operations but doesn't push such strict limits on what they do.
The activities Mr. Volcker criticized have caused banks to incur major losses in recent years. Nonetheless, proprietary trading and related activities appear to be making a comeback as markets have thawed.
Mr. Volcker said banks should be banned from "sponsoring and capitalizing" hedge funds and private-equity firms, which are largely unregulated. He also said "particularly strict supervision, with strong capital and collateral requirements, should be directed toward limiting proprietary securities and derivatives trading."
He also said collateral and leverage restrictions against the largest nonbank financial institutions "may be needed."
The comments reflect Mr. Volcker's long-held view that banks should act more in line with their traditional role and not take extremely risky gambles, which could threaten the viability of commercial banks and expose the Federal Reserve and taxpayers to large risks. Asked after his speech if his comments represent a break with the White House's proposal, he replied: "Nothing I said today should be a surprise" to the administration.
Mr. Volcker said he would appear before Congress next week to discuss his views in more detail. A Treasury Department spokesman declined to comment.
Stepping into the debate about who should be the top regulator for U.S. financial markets, Mr. Volcker said the Fed is better equipped than a "conclave" of regulators to oversee systemic risks to financial markets.
Regulating the financial system is "the natural responsibility for the Federal Reserve," he said, adding that other regulators are often "protecting their turf."
The White House has recommended giving extra power to the Fed but has run into opposition in Congress and from other regulators.
Mr. Volcker acknowledged the central bank would likely need some changes of its own to meet the new challenges. He said the Fed had "been more controversial" recently than he would have liked and had "not done things perfectly in the past."
"The Fed needs some reform internally," he said. This should include some "organizational changes" that he didn't specify.
Mr. Volcker also said there are signs that the economy is in the "early stages of recovery" but that it would take several years to reach "something approximating full employment." He also cited a risk of "some relapses along the way."