Making the Volcker Rule Better for Markets and the Economy: View
The Volcker rule, a central element of the U.S. financial reform effort, is facing heavy criticism as regulators prepare a final version. We encourage them to stick as close as possible to the rule’s original intent: severing the links between high-stakes securities trading and the banking services crucial to the broader economy.
Inspired by former Federal Reserve Chairman Paul Volcker, the rule forbids proprietary trading, or the use of a bank’s own funds to make speculative bets. This has two main aims: prevent losses on such trades from reducing banks’ ability to lend, and cut traders off from the taxpayer subsidies implicit in federal deposit insurance, emergency central-bank credit and government bailouts.
In recent days, big banks, investment managers and even the governments of Germany, Japan and the U.K. have lamented what they see as the rule’s adverse effects. Their primary complaint relates to an exemption -- inserted in the legislation by the finance industry’s lobbyists -- that allows banks to engage in the business known as market making. This useful activity, which helps customers buy or sell financial instruments, is dominated by a handful of U.S. banks. It can be difficult to distinguish from proprietary trading because both tend to involve buying and selling for the bank’s own account. Market makers do so in anticipation of clients’ needs. Prop traders do so solely to make bets with shareholders’ and creditors’ money.
The rule’s critics worry that aggressive efforts to eliminate proprietary trading will complicate market making, leading banks to charge more for the service or pull out of the business entirely. This in turn could prompt investors to demand a higher return to compensate for the extra difficulty in making trades, thus increasing borrowing costs for governments and companies. One study, commissioned by a financial-industry trade group, estimates that the decreased liquidity -- that is, the impaired ability to trade quickly and inexpensively -- could add as much as $43 billion a year in borrowing costs for U.S. corporations, while knocking as much as $315 billion off the value of existing corporate bonds.
There are many reasons to question the validity of such analyses. First, they assume that if the rule puts a chill on market making, the structure of the market would remain the same. Unlikely. If big banks such as JPMorgan Chase & Co. and Citigroup Inc. pulled out or charged more, smaller dealers that are not banks, such as Jefferies Group Inc. and Cantor Fitzgerald LP, would probably step in to fill at least part of the void.
The altered environment might also spur new and more efficient ways to match buyers and sellers, much as high oil prices encourage the development of alternative energy. Corporations and governments might seek to address the lack of standardization in bond issues, a characteristic that makes them much less liquid than stocks.
Second, the Volcker rule’s critics talk as if liquidity is an unmitigated good. Questionable. Economists from Keynes to Larry Summers -- and more recently, Adair Turner, the chairman of the U.K. Financial Services Authority -- have suggested that higher transaction costs could be beneficial because they favor long-term investment over short-term speculative trading.
Beyond that, market makers must always stand ready to take a client’s trade, no matter what. Consider the financial turmoil of 2008, when securities firms were trying to get rid of mortgage-backed investments that were rapidly becoming worthless. Is it really desirable that federally insured institutions be among the buyers in such a situation?
Finally, estimates of the Volcker rule’s costs tend to ignore its potential benefits, which include protecting the economy from trading losses. The Government Accountability Office has reported that the six largest U.S. bank holding companies lost nearly $16 billion on proprietary trading in the 18 months ending December 2008. Assuming banks can lend about $10 for every dollar in capital, the losses reduced banks’ lending capacity by at least $160 billion, at a time when the economy desperately needed the money. The GAO’s number doesn’t fully account for tens of billions of dollars in further losses on complex mortgage securities, which banks didn’t classify as proprietary trades.
One genuine danger of the Volcker rule, as currently written, is that it could impose requirements that nobody can reasonably follow or enforce. It offers, for example, 17 quantitative measures by which regulators will assess whether banks’ market-making activities constitute proprietary trading. Even a genuine market-making operation might look proprietary by some measures. As a result, regulators will be drawn into debates with banks about which indicators really matter. The effect could be chaos -- without actually preventing proprietary trading.
As they craft the final rule, regulators should pare down the measures to the few that are most relevant. One to consider keeping is how much a bank’s market-making desk could lose in various worst-case scenarios. As long as the value at risk is no larger than it was before the financial crisis, chances are the bank isn’t adding any proprietary trading to its market-making activities. Another is how long the trading desk has been holding its inventory of securities. Some kinds of distressed debt can take months to find a buyer, but the average for a big market-making operation should be a matter of days. A third is what percentage of trades a desk makes with clients, as opposed to with other securities dealers. If most trades are with customers, one can be reasonably sure the bank is engaged in bona fide market making.
For financial companies that view these measures as too onerous, regulators could offer an alternative: Allow financial holding companies to engage in proprietary trading as long as they split their banking and securities activities into independent, separately capitalized entities. Regulators in the U.K. have already adopted this approach, known as ring-fencing. The banks wouldn’t be allowed to lend to financial firms, and the securities side would be subject to capital and liquidity requirements that vary with size, risk and systemic importance.
The upshot: The securities side won’t enjoy the bank’s taxpayer-subsidized borrowing costs, and the bank won’t be directly exposed to trading losses -- fulfilling the Volcker rule’s intent. Liquidity should hardly be affected at all, mitigating the concerns of foreign governments and investment managers.
It’ll be difficult to find a version of the Volcker rule that executives at the largest U.S. banks will love. But as long as it makes the economy more resilient to financial shocks without unduly gumming up markets, it will be good for America.
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