Treasury Secretary Jacob J. Lew has strongly urged federal agencies to finish writing the Volcker Rule by the end of the year — more than a year after they had been expected to do so — and President Obama recently stressed the importance of the deadline.
By the way, five (!) agencies are writing the rule, which is not a good sign. As for the Volcker rule more generally, here are a few points:
1. If restricting activity X makes large banks smaller, that will ease the resolution process, following a financial crack-up. That is a definite plus, although we do not know how much easier resolution will be.
2. It is not clear that banning bank proprietary trading will lower the chance of such a financial crack-up. The overall recent record of real estate lending is not a good one, and as Edward Conard pointed out, restricting banks to the long side of transactions is not obviously a good idea. I do see the moral hazard issue with allowing banks to engage in the potentially risky activity of proprietary trading. Still, so far the data are suggesting that the banks which cracked up during the crisis did so because of overconfidence and hubris, not because of moral hazard problems (i.e., they still were holding lots of the assets they otherwise might have been trying to “game”).
3. There is no strong connection between proprietary trading and our recent financial crises.
3b. Today the bugaboo is “big banks” but once it was “small banks” and for a while “insufficiently diversified banks.” Maybe it really is big banks, looking forward, or maybe we just don’t know. Small banks have their problems too.
4. There is some chance that proprietary trading will be pushed to a more dangerous, harder to regulate corner of our financial institutions.
5. There is some danger that loopholes in the regulation itself — especially as concerns permissible client activities — may undercut the original intent of the regulation. This will depend on exactly how well the regulation is written, but past regulatory history does not make me especially confident here. And the distinction between “speculation” and “hedging” cannot be clearly defined. Should we be writing rules whose central distinctions may be arbitrary? And yet CEOs will have to sign off on compliance (with 950 pp. of regulations) personally. Is that a good use of CEO attention? Here is a good FT piece about how hard (and ambiguous) it will be to enforce the rule globally.
6. I do not myself shed too many tears over the “these markets will become less liquid with banks’ own participation” critique, but I would note this is a personal judgment and the scientific status of such a claim remains unclear.
7. Many people, even seasoned commentators, approach the Volcker rule with mood affiliation, starting with how much we should resent our banks or our regulators or how we should join virtually any fight against either “big banks” or regulators. I see many analyses of this issue which spend most of their time on “mood affiliation wind-up,” as I call it, and not so much time on the actual evidence, which is inconclusive to say the least.
8. We still seem unwilling to take actions which would transparently raise the price of credit to homeowners. We instead prefer actions which appear to raise no one’s price of credit and which are extremely non-transparent in their final effects. You can think of the Volcker rule as another entry in this sequence of ongoing choices. That should serve as a warning sign of sorts, and arguably that is a more important truth than the case either for or against the rule.
When I add up all of these factors, I come closer to a “don’t do the Volcker rule” stance in my mind. The case for the rule puts a good deal of stress on #1, but overall it does not fit the textbook model of good regulation. I probably have a more negative opinion of “an extreme willingness to experiment with arbitrary regulatory stabs” than do most of the rule’s supporters, and that difference of opinion is perhaps what divides us, rather than any argument about financial regulation per se.
I really do see how the Volcker rule might work out just fine or even to our advantage. I also see the temptation of arguing “I am against big banks, this is the legislation against big banks which is on the table, so I am going to support it.” But let us at least present to our public audiences just how weak is the evidence-based case for doing this.
Addendum: You will find a different point of view from Simon Johnson here. Here is a counter to his claim that prop trading losses were significant in 2008: “Loan losses didn’t just dwarf trading losses in absolute terms. Loan losses as a share of banks’ total loan portfolios also exceeded trading losses as a share of banks’ trading accounts. Yet no one’s arguing banks should stop lending in order to protect depositors (and rightly so). In short, those expecting the Volcker Rule to be a fix-all for Wall Street’s ills have probably misplaced their hope—the rule seems like a solution desperately seeking a problem.”