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Nearly two years ago, in the wake of the financial crisis, Congress passed and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. Part of that law, the Volcker Rule-which prohibits banks and their affiliates from engaging in bond trading for their own account-is garnering a lot of attention in Washington these days, none of it positive.
Delegations from foreign countries have complained about its effect on sovereign debt. A bipartisan group of senators has recommended a delay in its scheduled implementation this July, and 26 House Democrats signed a letter pointing out that teachers, police officers and private employees’ pension funds stand to lose because of the rule. Even Rep. Barney Frank, co-author of the provision, has urged regulators to simplify it.
Simplification sounds like a reasonable idea, but it’s much easier said than done. The regulation is almost 300 pages and contains over 1,000 separate questions for banks and their associates. That’s not because the regulators delight in abusing the regulated, but because the regulators are grappling with an impossible problem-how to prohibit proprietary bond trading while preserving bank activities that are vital to the health of the capital markets.
For example, banks are market makers for all kinds of debt securities, and they stand ready in that capacity to buy or sell bonds and other fixed-income obligations at the market price. If they did not perform this function, individuals, corporations, pension funds and others would not be able to liquidate their assets when they need cash or want to change the composition of their holdings. Yet, in making markets, a bank is clearly trading for its own account.
Moreover, bank bond trading adds vital liquidity to these markets—without it, the spreads between bids and asks would be much wider, making it more expensive to buy or sell fixed-income securities. Even Congress knows this. That’s why it exempted U.S. government securities from the prohibition on proprietary trading by banks. This allowed the U.S. Treasury to sell its securities more cheaply, but it enraged issuers of foreign sovereign debt that were relegated to less efficient markets.
To forbid proprietary trading while still permitting banks to act as market makers and trade for customers requires a sufficiently bright line to assure banks that they will not be violating the law when they carry on a permissible trading business.
But Paul Volcker himself, the former Federal Reserve chairman and Obama adviser for whom the rule is named, could not define that line when testifying before Congress in 2010, finally resorting to a quip: “It’s like pornography,” he said, “you know it when you see it.”
That may work for former central bankers like Mr. Volcker, but not for bank lawyers. Banks will stop their activities if their compliance with regulations isn’t assured.
It’s not as though proprietary trading of debt securities by banks is some new idea that sprang from the mind of a Wall Street quant. Bank regulators, including the Fed when it was headed by Mr. Volcker, have always permitted banks to buy and sell whole loans, bonds, notes and commercial paper, as well as securities backed by car loans, credit-card receivables and mortgages.
This is only logical. As lenders, banks should be able to buy and sell the assets that are their stock in trade. To forbid this activity would be like prohibiting Exxon Mobil from trading oil.
So why is proprietary trading by banks now to be prohibited? Although Dodd-Frank was intended to prevent future financial crises, no one has yet been able to point to bank proprietary trading as a factor in weakening the banks before the 2008 financial panic.
Until the fever for punishing banks seized Congress in 2009, no one had objected to the bank trading activity that is now forbidden. That fever allowed Mr. Volcker—who has always favored banks focusing solely on taking deposits and making loans—to propose limits on other bank activities and investments, arguing that using insured deposits for proprietary trading was excessively risky.
But the financial landscape has changed dramatically since Mr. Volcker left the Fed in 1987. Bank lending has declined as a factor in corporate finance, and banks have assumed a major role in far larger and more efficient capital markets.
For this reason, allowing banks to trade for their own account is now good banking policy. Not only is this a profitable business for which banks are uniquely qualified, but it enables them to diversify their activities away from corporate lending, where they’ve been outdone by more efficient securities markets. For many years, companies large enough to access the securities market have been able to meet their financing needs less expensively by issuing bonds, notes and commercial paper instead of borrowing from banks.
Banks, in turn, have been forced to concentrate their lending in the volatile business of real-estate finance, particularly local real-estate development. In 1965, less than 25% of all bank lending was based on real estate, but by 2008 this number was 55% and climbing. If this continues, real-estate downturns will lead to more banking crises.
Bank proprietary trading, however, is a win-win—it benefits the markets while providing banks with a revenue stream other than lending. Regulation is at its worst when it prevents an industry from responding to changes in the market it serves.
Calls for “simplification” of the Volcker Rule are profoundly misguided. The circle can’t be squared. The Volcker rule is complex because Dodd-Frank requires the regulators to make distinctions—between proprietary trading and market making—that simply can’t be made by the blunt instrument of regulation.
The fundamental question is whether we want banks to act as market intermediaries or not. If a case can be made that this is somehow dangerous or will lead to another financial crisis, then let’s have someone make it. If the case can’t be made—and it hasn’t yet been made—then the Volcker Rule should be repealed.
Mr. Wallison is a senior fellow at the American Enterprise Institute.
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