Quantcast

Explainer: Why Do We Need a Volcker Rule? | The Nation

  •  

Explainer: Why Do We Need a Volcker Rule?

  • Share
  • Decrease text size Increase text size

As the provisions of the Dodd-Frank financial regulatory law begin to go into effect, federal oversight agencies have issued the first draft of the “Volcker Rule.” Named for former Federal Reserve chairman Paul Volcker, the Volcker Rule says that commercial banks shouldn’t be able to make risky bets with federally insured deposits. The Roosevelt Institute’s Mike Konczal talked to The Nation about what the Volcker Rule is and why it’s necessary. Here’s Mike:

The Volcker Rule is best understood as an attempt to update the New Deal–era Glass-Steagall for the twenty-first century. Glass-Steagall called for a complete separation of investment banking—the activities of underwriting and dealing with stocks and debt—from deposit taking. Consistently weakened from the 1980s onward, Glass-Steagall was fully repealed in the late 1990s to allow Citicorp to merge with an insurance company.

About the Author

Mike Konczal
Mike Konczal is a Fellow at the Roosevelt Institute. He blogs at Rortybomb and New Deal 2.0.

The Volcker Rule seeks to keep activities essential to banking within a safety net, while excluding other, riskier, activities from this safety net. There are a variety of special regulations, and protections, banks get, ranging from federal deposit insurance (known as FDIC) to access to the Federal Reserve’s discount borrowing window, designed to keep the system working through panics. Banks currently engage in a wide variety of non-banking activities with safety net protection. For example, they speculate in currencies and run hedge funds and proprietary trading desks for their own benefit. These activities made the financial crisis worse; one estimate has the major Wall Street firms suffering $230 billion dollars in prop trading losses a year into the crisis. And right now, these activities are subsidized by access to the banking safety net.

The New York Times says, “A main element to the plan would bar banks from making proprietary trades—using their own money to place directional market bets that are unrelated to serving customers.” Can you break this down for us?

Proprietary, or “prop,” trading are directional bets made for a firms’ own accounts, with their own resources, for their own gain. This is different from trades done for clients on commission. Under a strong Volcker Rule, any securities market activities would have to be intended to serve customers—not market-making bets for the bank’s own profits. Prop trading is very common among the largest financial institutions, many of which were bailed out during the 2008 financial crisis, and among the firms that are targeted by Dodd-Frank. These large, systemically risky firms are also a big presence in hedge funds and private equity operations. Bank-affiliated funds were responsible for over a quarter of private equity investments over the past thirty years. Bear Sterns ran two hedge funds. Its collapse, the first major collapse of the financial crisis, resulted in part from those two hedge funds experiencing spectacular losses over a short time window.

Many financial regulations are aimed at leveling the playing field between two agents. For example, making sure your bank isn’t misleading you on the terms of a mortgage is an important part of regulations after Dodd-Frank. The Volcker Rule helps with the conflicts of interest between banks and their clients. But it also provides for the stability of the economy as a whole. The financial system has the ability to disrupt a huge part of the economy in a panic. The Volcker Rule, by removing the “casino” part of the financial system from the core banking parts, will make panics less likely and more manageable when they do.

Don’t actions taken in the bank’s benefit ultimately benefit customers—and/or shareholders?

These actions ultimately benefit the banks themselves, not their clients. Indeed, many of the activities can come at the expense of their clients. They may benefit their shareholders, but we didn’t create the set of regulations and the banking safety net in order to benefit shareholders; we did it to manage panics and contagion, or the way panic spreads, in the financial markets.

The lines are difficult to draw; one of the major problems with how the Volcker Rule has proceeded so far is that these lines aren’t drawn much sharper and they presume too much of the regulator’s ability to determine intentions, among other obscure things.

A group of senators opposed to the rule have signed a letter worrying that “As market-makers reduce or eliminate inventory, liquidity is reduced and trading spreads widen…. This will increase trading costs paid by investors, thereby reducing returns for investors large and small alike.” Do you buy their argument?

The short answer is that if you ask banks to divest of their current prop trading activities, other financial firms will step in and take over this business. The market is robust enough, and the potential to profit from these activities great enough, that we will see these needs being met by firms that aren’t inside the banking safety net.

Financial lobbyists explicitly acknowledge that they use studies that “do not directly analyze a wide range of potential knock-on effects, including…[t]he potential replacement of some proportion of intermediation currently provided by Volcker-affected dealers by dealers not so affected.” But these so-called “knock-on effects” are exactly the purpose of the Volcker Rule—it is designed to move some risky financial activities away from protective financial infrastructure.

As financial expert Wallace Turbeville noted in Congressional testimony, the Volcker Rule “may actually support more liquid markets by ensuring that the banks focus on providing liquidity as market-makers.”

The SEC’s comment period for the rule recently wrapped up, and the proposed rule drew a blizzard of reaction. Do you share any of their concern about the complexity of the rule and how hard it will be for banks to follow it?

Lobbyists for the financial industry argue that the system as a whole is fine, and that attempts at reform will simply increase costs for business. But as I said, having banks focus on core market-making activities and leaving replacement of many of these functions to the market will be best for the financial markets.

Are there concerns about the Volcker Rule that progressives should take seriously?

Short answer: yes. There are two sets of concerns about the Volcker Rule that progressives should engage with. The first is that by moving prop trading from the banks to other entities those practices will become harder to regulate, and it will be more difficult to detect and stop harmful activities and more problematic to resolve when things go wrong. The correct way to deal with this is to require strong implementation of the rest of Dodd-Frank, especially when it comes to derivatives and hedge funds. Dodd-Frank also allows for application of the Volcker Rule to systemically important financial institutions that are not banks, which is essential.

The second is very important, and that goes to the rule’s complexity. In a piece in The Nation, Carne Ross wrote, “It is self-evident that legislators cannot predict or legislate for products that have yet to be invented. Even if Washington were interested in robust legislation and ending the monopoly powers of a few big banks, it would still struggle to manage an industry in constant flux.”

The best way to create forward-looking regulations is to have clear boundaries and clear penalties. This makes it harder for financial instruments and practices to try and blur the line between the two, practices we saw undermining the New Deal financial regulations. It is easier for regulators to oversee the relatively straightforward parts of the core banking business model that the largest banks participate in, and regulate them accordingly. The more the banks deviate from core banking services, the harder it will be to monitor these financial firms.

The current rule is far too complex to carry this out. Even Paul Volcker has criticized the rule for its length and complexity. Instead of laying out “definitive bright lines,” Federal Reserve Governor Daniel Tarullo testified, the authors of the Volcker Rule designed it to take a “nuanced approach.” But, as Occupy the SEC argued in their comment letter, this will “confuse mere complexity for nuance” and that “simple bright-line rules make the compliance process easier, both for the regulated and for the regulator.”

Dodd-Frank is a series of reforms. Each of them, when done right, reinforces the others. Large, systemically risky firms, are required to hold more capital and to create “living wills” that allow them to be taken down in a financial crisis. FDIC regulators are given powers to do “resolution” on these financial firms, in the same way FDIC takes over and winds down local banks. If the Volcker Rule is done correctly, firms are less likely to collapse quickly and in a panic. This makes resolving and taking down firms that much easier. And it means misjudging the amount of capital necessary for a bank to hold is less of a problem.

Most of the other major pieces of Dodd-Frank are matched with an agency that wants strong implementation. The FDIC wants to end “too big to fail” through resolution authority. Gary Gensler at the CFTC wants to see strong derivative rules. The staff of the CFPB wants to see their agency start off strong. But no single regulator is trying to get the strongest Volcker Rule possible. Assigned to five different agencies, it is important that activists fight for a strong Volcker Rule to be enacted.

  • Share
  • Decrease text size Increase text size

Before commenting, please read our Community Guidelines.