The Volcker Rule: The Wrong Track Toward the Right Objective
On the one hand, it’s hard to disagree with the angst bankers have shown over the so-called Volcker Rule. The confusing language, the unforeseen problems in its 300 pages, and its detailed mandates could cause more trouble for firms and taxpayers than it solves by leading some to consider the closing of profitable European investment funds that pose no systemic threat to financial safety and soundness. Its convoluted objectives have even estranged the bill from the Big Man himself, Mr. Volcker.
On the other hand, these are the same small group of colossal institutions that played casino in the subprime mortgage market, using insured deposits as their chips. Except in this casino, the house was destined to lose either way. And without some kind of control, it is likely they will succumb to the temptation of playing with the house money again.
Dodd-Frank Emphasis Is Misplaced
The slapdash manner in which Dodd-Frank adopted the Volcker Rule provisions helped create many of the questions that people are asking today. After all, it was the lending operations of these major institutions that brought the global financial system to the brink, so why try to shutter their trading operations? The derivatives instruments that these trading operations were marketing may have played a significant role in the 2008 meltdown, but they were covered by a different section within D-F, so, again, what was the point?
One could make a very strong and valid argument that the purpose of the Volcker Rule is to prevent a disaster that is waiting to happen. We may have gotten lucky in 2008 that the trading desks didn’t create even bigger problems for the global financial system, and so we should take action now to ensure that we never have to see what those problems might look like. Yet, as the MF Global fiasco shows, regulatory agencies are not very adept at preventing even the kinds of problems that decades of new rules were intended to prevent. So why should we expect this particular rule to succeed where others have failed in the past?
Worse for regulators and institutions, alike, is that the Volcker Rule deals in degrees. Banking institutions are prohibited from engaging in proprietary trading and are not permitted to own, sponsor, or have certain relationships with private equity or hedge funds. At the same time, they are permitted to underwrite securities, make markets in securities, and actively buy and sell instruments to hedge certain exposures. At best, the lines between prohibited prop trading and these exempt activities, for example, are blurry. At worst, they do not exist.
Similarities to Glass-Steagal
In many ways, the Volcker Rule is an attempt to create a modern version of Glass-Steagal, whose primary concern was the potential for conflicted interests of banks if they underwrote the common stock of commercial enterprises, and the potential negative effects these activities might have on retail deposits. Indeed, at the time that Glass-Steagal was repealed in 1998, securities underwriting remained the dominant piece of the investment banking business model, thanks to the underwriting of new technology, Internet, and telecom companies.
The status quo was already changing by then, however, as the massive leap in computing power had enabled firms to improve upon the algorithmic trading systems that were first employed by trading firms in the mid-1980s. In the decade following the repeal of Glass-Steagal, trading took on greater significance for the traditional investment banks, eventually finding its way to the big commercial banks.
So here we are in 2011, trying to implement a 2010 rule created to prevent a recurrence of the liquidity crisis of 2008 by blocking a system accidentally created by a 1998 law that repealed a 1930s law, none of which have been shown to cause any of the problems experienced in the past four years.
In all seriousness, banks have no business taking advantage of low-cost, taxpayer-backed deposits to engage in capital markets activities. Beyond the potential systemic problems of such a system, it gives these firms a massive cost advantage against smaller, uninsured trading firms. It even gives them a cost advantage against smaller, non-trading banks.
So, if these institutions wish to engage in proprietary trading, they should do so on the basis of their own balance sheets, not the nation’s. Living under this kind of structure might limit the ability of such firms to employ the kind of leverage evident over the past decade. And if they are to benefit from a public guarantee of their primary deposit funding source, then the least that can be asked of them is to safeguard those deposits from such activities.
Is Ring-Fencing the Answer?
In Canada they have done this by ring-fencing the deposit-taking part of their universal institutions from the higher-risk activities of trading, investment banking, private equity, or hedge fund management. Based on this system — not to mention full recourse mortgage loans and no taxpayer subsidy for mortgage interest, among other things — Canadian banks did not experience the kind of problems that their counterparts south of the border did a little more than three years ago. This was despite having a greater concentration of deposits and assets among a very small group of institutions. The United Kingdom is following suit by choosing to adopt the ring-fencing suggestions in the Vickers Report.
The idea to separate “high street banking from investment banking” is not without its detractors. Some researchers rightly point out that separation still leaves banks that remain too big to fail. Moreover, ring-fencing does little to prevent bankers from making systemically bad lending decisions.
But in one sense, the Volcker Rule is on the right track in that it tries to safeguard retail deposits from the higher-risk activities of modern universal banks. And as Canada has shown, such safeguards do not require the evisceration of a financial institution’s legitimate activities. It just requires better, smarter, and more courageous regulation and oversight.