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Reading the lengthy background paper that accompanied Tuesday’s release of the Volcker Rule, it is striking the extent to which the five federal regulatory agencies involved sought to implement the law faithfully (as they put it) by prohibiting proprietary trading by banks while avoiding the worst potential negative impacts on financial markets.
President Obama explained that the idea was to have “a rule that makes sure big banks can’t make risky bets with their customers’ deposits” — the concern being that taxpayers guarantee most bank deposits. In reality, banks take risks with customer deposits every day, since their lending to families and businesses are funded with deposits, among other sources. This credit is vital to the economy, but involves risk: witness the multitude of banks that failed during the crisis because of losses from poor real estate loans.
Following the suggestion of Mr. Volcker, Congress in the Dodd-Frank financial regulatory reform legislation viewed proprietary trading and hedge fund investments as particularly risky and therefore to be kept mostly apart from banks that rely on taxpayer guarantees.
Last year’s London Whale trading episode illustrates that banks indeed can lose prodigious amounts of money when trades go wrong. But just as the Whale did not nearly threaten to sink JPMorgan Chase, neither did proprietary trading appear to have been an especially important factor behind the recent financial crisis. Moreover, the large banks with the most active proprietary trading desks mostly rely on funding sources other than insured deposits. Trading is an important activity at Goldman Sachs, for example, but relatively little of the firm’s funding is insured by the federal government. There is a sense, then, in which the Volcker Rule is a solution in search of a problem. Still, it is the law.
An important reason that it took the regulators so long to devise the rule is that while most proprietary trading is forbidden, market-making under which banks bring together buyers and sellers of securities is permitted. But both activities involve trading, making it potentially difficult to distinguish when a particular trade crosses the line from serving a customer to putting on a bet for the bank.
If the prohibition on proprietary trading were to lead to an unintended reduction in permissible market-making, this might reduce market liquidity and lead to higher borrowing costs for businesses and families. This in turn would mean less investment and spending and thus a weaker economy and slower job creation. Even cracking down on supposedly risky trading might only lead this activity to migrate to parts of the financial system that are less well regulated than banks. If proprietary trading is risky for society (not just for shareholders of JPMorgan and other banks) — not at all clear — then the risks would be hidden in the shadows rather than disappear. It made sense for the regulators to take the time to get the rule right.
Both Congress in writing the Volcker Rule and regulators in putting it into force appear to have recognized the trade-off between regulation aimed at lending stability to financial markets on the one hand and the concomitant adverse effects on economic growth and efficiency on the other. Cognizance of this trade-off can be seen in the exemption in the Dodd-Frank legislation of United States government securities from the ban on proprietary trading. This is even though banks can suffer losses while trading Treasury bonds just as on any other security. But presumably Congress understood that it would be a self-inflicted wound to reduce the liquidity of the Treasury bond market and thus increase borrowing costs for the government. In the final rule, the exemption is extended to trading in state and municipal government bonds, and in part to trading in the sovereign debt of other nations.
Regulators were further careful in allowing banks to use trading for the purposes of hedging — that is, undertaking transactions meant to lay off exposure to certain risks to other investors. For hedging, the rule specifies that the hedge must be against identifiable risks associated with specific investment positions. This seems both reasonable and useful. After all, banks should be doing this analysis on their own to identify and assess the risks in their portfolios. The Volcker Rule will force them to write the analysis down — to specify in advance the way in which a particular trade serves as a hedge. That might be cumbersome, but presumably banks will devise automated systems to help traders comply. The real problem would be if the compliance boxes are routinely ticked and substantive risk management avoided, but that is an age-old struggle within financial markets between investors and regulators.
It is hard to know the full impact on markets until the Volcker Rule is fully in place in 2015, but my sense is that the regulations put out on Tuesday will allow banks to continue in their roles as facilitators of trading.
In putting out the rule, the federal regulators stated that they would collect and analyze data relating to firms’ trading activities, and make adjustments in response. This data-driven approach featuring flexibility and a staged implementation matches the recommendations of a report from the Bipartisan Policy Center’s Financial Regulatory Reform Initiative, a project on which I am a co-director. It is heartening for the regulators to put in writing that they are committed to “revisiting and revising the rule as appropriate.”
Banks might wish that the Volcker Rule did not exist, but that discussion is long moot. It turns out that the rule as promulgated could add some useful risk-management processes by ensuring that firms understand their own hedging strategies while doing only modest harm to the economy through the impacts of reduced liquidity in financial markets.
An irony is that Volcker Rule proponents see the final result as “tougher than expected,” pointing to symbolic measures such as requiring chief executives to attest that the required processes are in place. This might be an instance in which both banks and their critics are satisfied with a regulation—though perhaps only until the banks’ critics realize the situation.
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