Views on improving the integrity of global capital markets
03 January 2012

The Volcker Rule: The Wrong Track Toward the Right Objective

Jim Allen, CFA

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.

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

5 thoughts on “The Volcker Rule: The Wrong Track Toward the Right Objective”

  1. pchepucavage says:

    Seoarating the two functions was widely debated but lobbied out of the final bill by the big banks. senator Blanche lincoln’s description of that activity is instructive ;
    As the Senate began the debating the financial reform bill, Bank Reform Bill 2010 in May, Senator Lincoln decided to take an tough stance against banks regarding derivatives trading.[2] Lincoln initially had success getting language into the bill (Section 716) which geared toward separating traditional banking activity from speculative activity in the derivatives or “swaps” market and separating the speculative activity from the taxpayer guarantee. Her provisions which were rolled into the larger Senate financial reform bill, “will force the biggest banks to spin off their swaps (or derivatives) desks into a separate entity. That entity will be regulated and can remain part of the bank holding company, but it no longer has access to the Federal Reserve’s flow of funds, FDIC insurance and the taxpayer guarantee. Supporters include legendary economists and public policy experts such as Robert Reich, Joseph Stiglitz, Nouriel Roubini, and Michael Greenberger.” [3] The derivatives measure in the bill will target the five largest banks that account for 90% of the these derivative measures. [4] ” Lincoln’s amendment will go right after the deals that Goldman Sachs is now being officially investigated for and Lincoln’s language is #1 on their hit list.” [5] “These five bank-dealers can fund their swaps trading units with FDIC-insured deposits. They have access to the Federal Reserve’s discount window, which allows them to borrow money for gambling in swaps at near-zero percent interest rates. But these government supports were created to reassure the public that their deposits are safe, and to protect banks from runs on their deposits –- not to help banks finance their own casinos.” [6]

    “The swaps business, which accounts for billions in bank profits, is so desirable that the banks have all but given up fighting other restraints on their derivatives business.” [7] Lincoln’s provision in the financial reform bill faces opposition from some big name officials. The chairman of the Federal Reserve and the Secretary of Treasury oppose the derivative measure, arguing that it goes too far. [8] Initially critical of the derivative provision, Paul Volcker has changed his stance on the amendment. [9] However, many of Lincoln’s supporters argue that the derivative measure in the bill correctly affirms bank’s separate role in serving the public. If a bank is acting within its traditional role as a public lender to consumers, it is entitled to public protection such as backing from the FDIC. [10] Wray continues to frame Lincoln’s bill in this manner: “Here is the choice she offers: you can continue with your derivatives, acting against the public interest, or you can be a bank. You cannot be both. Take your choice: blood-sucking vampire squid? Or, serve the public interest. If you go for squid, you lose all public protection. In that case, you go “free market” with all that entails-higher costs of borrowing, 100% downside risk, and prosecution when you lie and deceive.” [11]

    Lincoln’s toughest challenge regarding the derivatives provision is that it is only included in the Senate Finance Regulation bill, not the House version. [12] “The banks have several strong allies on Capitol Hill when it comes to diluting the Lincoln provision. House Financial Services Committee chair Barney Frank is not in favor of the provision. Nor is Senate Banking Committee chair Chris Dodd. FDIC head Shelia Bair and Fed chief Ben Bernanke are also reportedly opposed.” [13] In contrast, Senate Majority Whip Richard Durbin (D., Ill.) said Ms. Lincoln is now in a stronger position. “She returns as the chairman of the Agriculture Committee, running for re-election in November, which I think gives her a strong bargaining position.” [14]

    Without Senator Lincoln’s efforts in addressing derivatives in the financial reform bill, there would be no other similar action. Congress has talked about getting tough with banks, but 18 months later, nothing has been done. [15] 97% of all swaps continue to be traded by five major banks. [16] “Lincoln’s amendment doesn’t end the trading. It does, however, force it onto a “transparent” market so everyone knows who’s trading what and at what price. Also, it would give regulators an unrestricted view of it for the first time and force derivative-trading banks to do so through an arm’s-length subsidiary so the Federal Deposit Insurance Corp. (and you and I) aren’t left holding the banks’ empty bags again.” [17]

    After House and Senate deliberating over merging the Senate and House versions of the bill, the final version of the Financial Reform Bill has watered down Lincoln’s derivatives provision originally in the Senate version of the bill. The final version of the bill will include this provision regarding derivatives: “require banks to spin off only their riskiest derivatives trading operations into affiliates. Banks would be able to retain operations for interest-rate swaps, foreign-exchange swaps, and gold and silver swaps among others. Firms would be required to push trading in agriculture, uncleared commodities, most metals, and energy swaps to their affiliates.” [18] This will tamp down speculation in important consumer commodities like gas and food, but do little to rein in speculation in other markets. The problem with the compromise is the fact that the credit derivative units that banks are allowed to keep comprise a great portion of the derivative business. Banks will be able to continue dealing interest rate and foreign exchange swaps, which make up the largest portion of derivative business. [19]

    As to eviscerating these big boys-they can figure out when they are facilitaing customers as opposed to trading for themselves.

  2. Timothy Hicks says:

    I would not necessarily look to the Canadian banks as the model. I don’t believe the “ringfencing” you describe has yet been implemented to the degree it will be once the regulators have their way. Also, the Canadian banks benefit hugely from having large percentages of their mortgage loans insured by the Government. In 2008, they were effectively bailed out by being able to sell mortages to the Government (CMHC) at marked-up prices. Once Canadian real estate starts to decline, which will happen when credit tightens, it will be very interesting to see what happens.

    1. Jeff Herold says:

      To say that the Canadian banks were “bailed out” is incorrect. During the credit crisis, short term funding dried up for solvent, profitable institutions, as well as insolvent ones. The mortgage purchases by the Canadian government were a means to provide substantial liquidity to the Canadian banks. The difference between the Canadian plan and similar ones implemented in the US and other locales was that the Canadain government bought performing loans, not toxic assets. The mortgages were purchased at values that resulted in substantial profit to the Canadian government.

  3. Roland Caldwell says:

    Seems mysterious to outsiders that Congress continues to be beholden to the big five, etc. Why is there still no willingness to admit that speculative activities cannot co-exist alongside traditional banking activities without ending up with a crisis.Inherent conflicts exist and human greed always has and always will prevail when the penalties are nominal. Political maneuvering to try to placate existing mega banks, who consistently supply Washington insiders with “experts” to make and manage U.S. fiscal policies, is ludicrus on its face. Only political lightweights can accept the unreality of this reality.

  4. pchepucavage says:

    Isn’t it time for the Institute to clarify where its stands with repect to the mega banks .Is it for or against the Volcker rule?

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