Don’t Dump the Volcker Rule Just Because It’s Not Perfect: View

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Oct. 10 (Bloomberg) -- Would you have provided motorcycle insurance to Evel Knievel? That is, in essence, what U.S. taxpayers are doing for risk-loving traders in some of the world’s largest banks.

This week, the first of several regulatory agencies will consider a measure aimed at ending the practice. Known as the Volcker rule, after Paul Volcker, the former Federal Reserve chairman, the measure would curb federally insured banks’ ability to make speculative bets on securities, derivatives or other financial instruments for their own profit -- the kind of “proprietary” trading that can lead to catastrophic losses. Whatever form it takes will be far from perfect. It will also be better than the status quo.

The bank bailouts of 2008, and the public outrage over traders’ and executives’ bonuses, laid bare a fundamental problem in big institutions such as Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. They attempt to combine two very different kinds of financial professionals: those who process payments, collect peoples’ deposits and make loans, and those who specialize in making big, risky bets with other peoples’ money.

When these big banks run into trouble, government officials face a dilemma. They want -- and in some ways are obligated -- to save the part of the bank that does the processing and lending, because those elements are crucial to the normal functioning of the economy. But in doing so, they also end up bailing out the gamblers, a necessity that erodes public support for bailouts and stirs enmity for banks.

Gamblers’ Threat

Although the gambling arms of the big banks weren’t the proximate cause of the last financial crisis, they do present a threat. If a big bet goes wrong -- as it has for so-called rogue traders at UBS AG and Societe Generale SA -- it can deplete the capital a commercial bank needs to fulfill its basic functions. That can hurt millions of people by curtailing lending and slowing economic growth.

The six largest U.S. banks lost a combined $15.8 billion on proprietary trading from the third quarter of 2007 through the fourth quarter of 2008, according to the Government Accountability Office. Because banks use leverage -- typically lending or investing about $10 for every $1 in capital -- a $1 billion loss can pull $10 billion out of the economy.

No Easy Task

Separating the bankers from the gamblers is no easy task. Commercial banks’ explicit federal backing -- including deposit insurance and access to emergency funds from the Federal Reserve -- is attractive to proprietary traders, who can use a commercial bank’s access to cheap money to boost profits. Bank executives like to employ traders because they generate juicy returns in good times that drive up the share price and justify large bonuses. In effect, both traders and managers are reaping the benefits of a government subsidy on financial speculation.

The Volcker rule will not -- and probably cannot -- fully dissolve the union of bankers and gamblers. The outline of the rule in the Dodd-Frank Act passed by Congress last year contains loopholes, such as one allowing banks to take on short-term trading risks as part of so-called market-making activities, in which they facilitate customers’ securities trades.

Judging from an early draft of the rule made public last week, regulators are looking at ways to narrow the exemptions and define proprietary trading as broadly as possible. One promising proposal would forbid banks from designing traders’ pay in ways that reward risk-taking. If such efforts prompt banks to view market making and the underwriting of companies’ stock and bond issues as too burdensome, that would be no great loss. Brokerage firms performed those functions successfully for decades before the 1999 repeal of the Glass-Steagall Act, which largely prevented commercial banks from entering the securities business.

No Guarantee

The rule also does nothing to address another problem: the teetering trading firm that is so interconnected and systemically important that the government will feel compelled to bail it out. Avoiding a repeat of the Lehman Brothers Holdings Inc. debacle is the role of other financial reforms, such as prudent capital requirements, centralized clearing of derivatives trades, and mechanisms that allow officials to take over and wind down financial institutions.

Even with all these drawbacks, the Volcker rule is worth doing. The greater the barriers become, the more likely gamblers will be to take their act elsewhere -- to hedge funds, for example. There’s absolutely nothing wrong with proprietary trading -- it just shouldn’t be done within the walls of federally insured, deposit-taking banks.

We understand the criticisms. Banks believe the Volcker rule will leave them at a competitive disadvantage to European and Asian counterparts that don’t face similar restrictions. That argument lost some weight last month, when the U.K. government endorsed rules that will require financial institutions to separate commercial banking from other activities.

Beyond that, it’s hard to imagine why safety wouldn’t be a selling point to potential investors, customers and creditors for a commercial bank. And if the U.S. government doesn’t provide subsidies to most other businesses, why should it provide them to the financial equivalents of Evel Knievel?

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