The Volcker Rule: A Needed Change That's Facing Senate Resistance

Includes: BAC, C, GS, JPM, WFC
by: The Rational Walk

It appears that the Volcker Rule is meeting a quick demise in the United States Senate only one month after it was initially proposed. The Volcker Rule is designed to limit the proprietary trading activities of commercial banks. A common complaint by opponents of the rule is that Paul Volcker made great contributions to the country during his tenure as Federal Reserve Chairman but is now too “out of touch” with modern finance and lacks credibility when it comes to reform proposals. Rather than debating the merits of the proposal, many opponents of the rule are simply implying that Mr. Volcker is too old to have valid ideas.

“Out of Touch” or “Voice of Experience”?

Mr. Volcker did not seem “out of touch” in his recent lengthy interview with the Financial Times, but it seems like pundits are playing right into the scenario outlined in Charlie Munger’s latest parable (however, Mr. Munger is old as well and, using the same line of “reasoning,” he may also be “out of touch” with modern finance).

Looking at the substance of the proposal rather than dwelling on Mr. Volcker’s age, it appears that he is advocating a simple rule-based policy that seeks to prohibit entities with a commercial banking license from engaging in proprietary trading activities that could later require resolution by the FDIC or, in the case of “too big to fail” institutions, large cash infusions from the government:

“Don’t expect the support you would get from being a bank within the club of insured deposits and access to the Federal Reserve and all the loving attention you get as a bank organization.” — Paul Volcker in Financial Times interview.

While it is true that there are cases where it may be unclear whether a financial institution is engaging in proprietary trading for its own account or acting on behalf of clients, a rule-based principle such as the Volcker Rule still has value in terms of setting the rules for the game and allowing the majority of financial institutions to adjust their business models accordingly.

Alternative Proposals are Unsatisfactory

The alternative proposals in the Senate are unsatisfactory because they do not offer a simple rule based regulation and instead direct regulators to micromanage banks in a manner that is likely to be ineffective and cumbersome. According to an article in The Wall Street Journal, Chris Dodd (D., Conn.) and Bob Corker (R., Tenn.) are negotiating the framework of a structure that will continue to allow proprietary trading but would give regulators more discretion to limit or ban “risky trading” at banks particularly when systemic risks are evident. Banks would be examined on a case-by-case basis and regulators would have the power to “limit or halt certain activities they felt were a systemic risk.”

After the events of the past two years, it is unclear why there are any grounds to believe that regulators will be able to understand the nature of proprietary trading books let alone selectively decide which positions pose a risk either to the financial institution in question or to the broader economy. The riskiness of a proprietary position may not be evident without examining a series of hedges and offsetting positions that even top bank executives have had trouble monitoring in the past.

Is Regulatory Micromanagement Feasible or Desirable?

Even putting aside the question of whether such regulation is feasible, one must consider whether it is desirable from the perspective of economic efficiency and preservation of a capitalist model. A simple rule based regulation such as the Volcker Rule spells out the prohibited activity in clear terms and regulators are charged with enforcing this “blocking” regulation. The alternative proposals have no simple rules but instead provide significant discretion to the regulators. The regulators will then have to micromanage the activities of banks and guide them through the inevitable “gray areas”. There will be ample opportunity for regulatory capture in such an environment.

The Volcker Rule is a modest attempt to reduce the overall level of risk in commercial banking and does not even approach the level of restrictions that were previously imposed under the Glass-Steagall Act. The entire post WWII economic boom in the United States was achieved under a system in which Glass-Steagall was in place. It is therefore unconvincing for opponents of the far more limited Volcker Rule to suggest that this modest regulation would harm the United States economy.

Those who support capitalism should support limited regulations that preserve the system or we may soon resemble the later years of “Basicland” in Charlie Munger’s parable.