Is the Volcker rule a good idea?

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 without banks’ 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.”


I would add another point. Just because the Volcker rule bans bank prop desks, doesn't mean that those trading activities cease to become profitable. In fact it largely pushes those same activities (many times the very same people and desks) out of the bank into the shadow banking system. For example below I linked a very typical story, about a renowned quant prop desk, PDT at Morgan Stanley, leaving the bank and spinning off into a hedge fund.

For all the bank failures that occur in financial crises, hedge funds and similar vehicles are much more unstable and prone to contagion. Typical hedge fund investors are sophisticated, leveraged and highly prone to withdrawing money in liquidity crises. In contrast banks have much more stable deposit base and other financing to fall back on. Moving prop activities from banks to hedge funds is going to lead to higher much less stability in these strategies during liquidity crunches.

Overall by itself that might be a significant factor. Who cares for example if OTR treasury spreads or merge arg premiums blow out a little further during crises. But hedge funds are basically the Typhoid Mary when it comes to spreading financial contagion. So moving more financial load onto them does significantly increase systematic risk.

A lot of thoughtful reflections here and important points to moderate people's excitement about the Volcker rule. But I don't understand how 1-8 add up to a "don't do the Volcker rule" stance. #1 is a minor point in favor of the rule. #4 seems potentially to be a minor point against it, except that it's undercut by #3 (if there's no reason to think that proprietary trading caused our recent financial crises, why should we be worried that the rule won't get rid of it?). The rest of the points seem to just amount to skepticism about the alleged benefits of the rule. That's fair enough, but to me that doesn't add up to "don't do the rule" without some reason for bias in favor of the status quo.

I take it that for most people the recent financial crises are a reason for bias against the status quo, a reason to do something rather than nothing, as long as that something isn't itself clearly a bad idea. Maybe there are reasons for being against "arbitrary regulatory stabs" in general. But there doesn't seem to be a complete case against this particular regulatory stab without presenting them.

Nice reply Paul.


Yes, good reply, but I would think bias should be against rules we have no evidence that would work. You could also ask why would we let the same group of regulators who allowed this mess try again. I would say there is as much evidence of new regulation damaging the economy as helping it. Especially lately.

Are Office Printers a complimentary good to the Volcker rule?

"Come Tuesday, hundreds of lawyers will pore over the details of the final draft, searching for loopholes and outlining for banks how they can comply with the law while still taking risks. One big law firm is installing extra printers in its conference rooms to print out multiple copies of the rule."

I would add:

The theory of the Dodd-Frank "skin in the game" rules is that banks must retain a stake in the deals they originate. They must not act solely as middlemen or brokers or originators, with no continuing role as principal. It's just too dangerous.

The theory of the Dodd-Frank Volker rule is that banks must not retain a stake in the deals they originate. It's fine for banks to act as middlemen or brokers or originators, but not as principals. It's just too dangerous.

As a practical matter, how can you force a bank to keep skin in the game? You can nominally require that they keep 10% of all loans they make, but in the real world they can just find a counter-party to hedge that risk, whether explicitly through swaps or insurance or implicitly by investing in things counter-cyclical to their assets.

Why not simply force the money center banks to spin off their broker dealers? It's not as if BofA or JPM get credit for large investment banks anyway, in fact Wells Fargo earns a higher multiple. And prop trading has essentially disappeared. These banks (including GS and MS) earn low single digit returns in their broker dealers. Nobody is making money on prop trading any longer because it's a lousy business. It's true that prop trading didn't have a huge role in the crisis, but here are the sorts of things that did: bridge loans to PE firms, holding mortgages created by the internal i-bank, exposure to Lehman Bros as counterparty. Eliminate the broker dealers within banks, and you eliminate those sorts of linkages. FDIC insurance for merchant banking is stupid and the banks should be the first to realize that.

And get rid of FDIC insurance for GS and MS. That just makes a mockery of the whole system.

"There is some chance that proprietary trading will be pushed to a more dangerous, harder to regulate corner of our financial institutions."

The point is not to regulate prop trading - we're all prop traders, buy a stock and you're a "prop trader." This sentence makes my head hurt.

The bank crises were caused by leveraging up mortgage assets on the bank balance sheet. A few points:

1. This was just a classic leveraged spread bet. IE agencies against treasuries. 30:1,
2. The purchasing of self generated assets from the internal structuring desks for investment banks was not the main reason for this exposure.
3. This leveraged spread trade was typically controlled and approved by senior bank officers, not proprietary traders, or traders of any type.
4. The banks who got into the most trouble (mostly investment banks) were not serious originators of mortgage loans in any real way.

Leverage or risk assets on the balance sheet is the issue here, not proprietary trading. Also management agency problems. How to regulate those is a difficult problem. Over regulation will lead to higher borrowing costs. But estimates of the implied bank solvency put written by the government are around 100 bn per yr. Add to that the knock on effects of economic disruption.

Ideally regulated and FDIC insured commercial banks would sell off most of their loan risk to pension funds and insurance companies and/or run as low leverage institutions.

Investment banks or hedge funds or other entities should be free to do what they want, without puts or bailouts. Since they are part of the shadow banking system and will be engaged in mysterious activities it's difficult to see how doing anything but regulating their absolute size (<5 bn in equity capital say - Bear Stearns was 11 bn prior to collapse, Goldman is around 20 bn now) might work, as crude as that sounds. This would in no way impact the advisory or capital raising role investment banks play.

So commercial banks like JPM and BAC should sell off loans - which is their whole reason for being - but keep their broker dealers?

They should originate loans - they can keep some but sell others. IE manage the loan portfolio risk. I see no reason the broker / dealer need to be affiliated with the traditional banking activities.

The reason is that there are economies of scale and scope. A broker/dealer is only effective if they have the requisite liquidity. Without broker/dealers or with restricted brokers, the markets become less liquid.

I agree with most of what you said, but banks keeping loans as assets helps reduce agency problems. Loans also have much higher yields which improves earnings and capital. Regulators are now requiring higher capital ratios and hence lower leverage.

The question never asked is what do we want the banks to be? The follow on question is what are they now? The big banks are mostly just rentiers skimming from the state run financial system, but they are in a lot of nooks and crannies of the system. The small banks continue the traditional role of retail banking, but even they are more or less agent-brokers for the big banks. That's all fine if that's the intent, but no one ever seems to say that so I don't know. The only thing is certain is the usual suspects will take issue with my characterization of the big banks. That largely proves my point and ties into point #8 in Tyler's post. If we cannot agree on what the banks are now and we cannot agree on what they *should* be after regulation, there's little point in passing new regs. In a vastly complex system like modern finance, even tiny changes will have unexpected and unwanted outcomes. Ham handed swipes at the system are sure to result in terrible downstream consequences. Therefore doing nothing is the wise course.

All fine and good in the abstract but"
a) who is "we,"
b) how likely is it that whomever comprises "we" will agree on what a bank should be, and
c) even if "we" do come to consensus, we'd have to remove the legal profession altogether since that's the engine behind this mess. If there's a loophole to be found, it'll be found and exploited as greatly as humanly possible.

I find it rather irksome that Tyler's discussion makes it seem as though the Volcker Rule is currently "legislation" "on the table," rather than part of a law that passed some 3 years ago. Yes, it is grotesque that 5 agencies must combine their efforts to bring the rule into existence; and yes, there are lots of reasons the whole thing may not be worth the candle. But in any case it is the law, and I don't see how that fact can be treated as quite so marginal in evaluating what regulators ought to be doing at the moment. (If this discussion is meant to be directed at legislators contemplating repeal of the rule, fine, but there is no indication of that at all.)

One of the issues with your argument is that the Volcker Rule isn't actually the law of the land yet until they write it, so it may be directed at those who can influence its writing to be as unharmful as possible.

Maybe in other countries the legislature passes laws and the executive enforces them, but that's not how things work in America. Here, the legislature asks the executive to write laws and the executive then takes three years and a billion dollars to not do it.

The law directed the agencies - all part of the Federal Financial Institutions Examination Council - to draft rules. The rules must follow the process of the Administrative Procedures Act. So no, it is not a done deal until the final notice is issued.

A ban on proprietary trading is controversial because these trades are often used for hedging risk. The trick is to distinguish between prudent and necessary hedging and imprudent gambles with insured deposits.

Finding a method to distinguish these behaviors is not watering down the law, although slick bankstas might be able to put one over on examiners for a little while.

Is this typical in lawmaking? To pass a law directing a third agency to draft rules? What if said agency decides to draft silly rules?

That is how America works.

That's the usual method. Congress passes laws into the United States Code, but the technical rules are in the Code of Federal Regulations. It is common for the agency that will enforce them to write them. This makes sense if you think of it from a "closest to the problem" perspective. I work in ocean transportation and most of "our" rules are written by the Coast Guard.

Interesting! So the actual minutiae of what goes into the CFR never gets a review by elected representatives?

Also what happens in case an executive agency is tardy or makes a halfassed attempt at fleshing out what it was asked to do in the statutory law? Is there historical precedent on this? If Dodd Frank don't like the details of the rules the agencies write do they have any legislative recourse to veto or override a clause?


In a word, yes, but the route is circuitous. If a person affected by a rule considers it unlawful, they may appeal to the agency and later sue under the APA or other applicable remedy. Rules by agencies receive deference as statutes as long they do not clearly violate the law, and courts will examine congressional intent.

Congress can influence agencies through the bully pulpit, threatening to clarify the law in the manner it chooses. But since the law is approved by all of Congress, the chief sponsors have no particular power to clarify their intent.

Laws are made by Congress but enforced by the executive branch. Obviously, this gives substantial power to the executive, is a critical part of separation of powers and checks and balances, and the source of much partisan bickering.

It's not just common, it is required by law under the APA. Agencies propose rules, open the rules for public comment, and then issue final rules and guidance.

#8 seems to me the fundamental issue: the idea that working-class families should be able to afford to buy a home is an entrenched element of our cultural psyche, even when disputed by financial reality. That belief will continue to be preyed upon (purposefully or not), regardless of attempts at regulation, especially since politicians aren't brave enough to confront it directly. More or less the same deal with our attitudes toward healthcare, too.

I don't know. The people actually wanting to buy homes (and often not being able to) are slowly adjusting their expectations of whether that's realistic:

The real beneficiaries of interest rates too low to accurately reflect risk are homeowners with few assets other than their house, who have a clear incentive to hold on to their equity at any price---and a bigger propensity to vote. With their children of increasingly little help (far away, increasing unemployed and possibly still at home themselves, simply indifferent), it's that equity that will be paying for a fair chunk of their assisted living expenses when the time comes. Realistic interest rates might not just tip us into another 2008 short-term. Long term, they may force older homeowners to greatly reduce their expectations for their "golden years" to something that they can realistically afford or their children can be persuaded to pay for voluntarily (trade in the Florida condo for a spare room of a child and an increasingly resentful spouse in a much colder state)---something that, as far as I can see, they simply refuse to do in any meaningful way.

Keep in mind that the lushest welfare benefits always go to the insiders. This is no exception.

So, the "actual evidence" is "inconclusive" and therefore you start with, "things are never as bad as people think". What's the difference between mood affiliation and first principles?

You don't understand at all - it's mood affiliation when someone to the left of Tyler (aka `a dirty hippie') does it.

Contrary to the Modigliani–Miller theorem, debt is not the same as equity. Debt is subsidized by the taxpayer, either implicitly or explicitly. The former for big 'favored' corporations (which get bailed out by Congress) and the latter for government. What this does is distort capitalism. So anything that forces banks to lend less, to make credit harder to obtain, to make people put skin in the game instead of using Other People's Money, is good.

So the Volcker Rule is good. An even better step is to abolish FDIC insurance, or scale it back to say $50k per account. I'm serious. Let equity replace debt.

This does not violate Modigliani-Miller at all. M-M posits that capital structure is irrelevant to a firm's total value *in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information*. Since the tax code clearly favors debt over equity financing, that is a disqualifying condition.

Yes, thanks. So the usefulness of M-M is zero. At least in engineering when I say "there is no friction" you can still build a so-called 'free body diagram' that usually explains 90% or more of the forces, and has predictive powers. By contrast, in economics often once you eliminate the necessary conditions to a theorem or hypothesis its predictive power is zero. Yet people still believe in Keynesianism, though in mitigation laboratory experiments have shown there is such a thing as sticky prices.

"Debt is subsidized by the taxpayer, either implicitly or explicitly"

How about just abolishing the tax exemption for interest?

If you invest $1M and earn $2M back ($1M profit), it makes a big difference if you claim to the IRS that it was a debt or equity investment.

With debt, the company you invest in is 100% tax exempt and you'd pay 43.4% plus about 5% state tax, for a total of about 48.4%. You'd keep $516k.

With equity, the company pays 35% plus state tax of about 5% for a total of 40%. Of the $600k you get, you pay 23.8% dividend tax and 5% state tax for a total return of $427k.

It's no wonder banks would prefer to load up the financial system with unsustainable debt. Of course, if you as an individual try to classify your investment as debt, the IRS will probably hunt you down and make you pay the higher rates. When a bank does it, it's presumptively okay. That's one of the keys of why the system works the way it does. (Mitt Romney made millions on the vig here by having banking connectons.)

My own view (and I'm a banking lawyer) is that the ban on proprietary trading will have an immaterial effect on the asset size of banking organizations. It might reduce their complexity.

An overlooked issue is that Volcker applies throughout the banking organization. That is, the ban on proprietary trading is not limited to the federally insured depository institution and restricts the activities of all of the affiliates of the depository institution. That's a dramatic expansion in scope, with questionable policy justifications.

Another overlooked issue is that Volcker also bans investments in certain types of investment funds. Some think this is simply a ban on investments in private equity and hedge funds that is intended to avoid regulatory arbitrage around the proprietary trading restrictions. The statutory definition of covered funds was sloppy, and so the covered fund restrictions are actually much broader - and without any apparent policy purpose. This is particularly a problem for foreign banking organizations, as it looks that Volcker will have a broad extraterritorial scope.

To me, one of the more interesting aspects of Volcker is its implications for administrative law. There are many who would prefer that Congress delegate less to the administrative agencies and instead legislate with particularity. The Volcker experience suggests that might not always work well. The statute defines "private equity and hedge fund," "proprietary trading," "solely outside the United States," etc. with particularity, but those definitions are generally not well-connected to the underlying policy concerns. The statutory language really left the regulators with few options to salvage a good and sensible rule. We probably would have been better off had Congress deferred more to the agencies here.

Finally, as a general matter, the difference between "security" (subject to the proprietary trading ban) and "loan" (not subject) probably isn't a distinction that matters when it comes to the safety and soundness of banking organizations. Stepping back a bit, it's hard to imagine what, why and how Volcker is up to.

@JPM: "My own view (and I’m a banking lawyer) is that the ban on proprietary trading will have an immaterial effect on the asset size of banking organizations" -- well, why is that not a surprise? So like Written Interrogatories, which almost never yield a straight answer, the Volcker Rule is vague and will be watered down by lawyers and case law until it does nothing.

Wall Street and Fleet Street win again, taxpayers lose. Doing God' D amn's Work!

The five agencies writing the rule are all part of the FFIEC - Fed, FDIC, NCUA, OCC, and CFPB. Most rules for financial institutions are written in the same manner. This fact is not particularly remarkable.

There are lots of good points and links here, but the Erel, Nadould, Stulz paper was full of tests that didn’t come close to proving what they suggest, including their alleged evidence that moral hazard wasn’t a factor (#2). Here’s the argument they put forward for this:

“The large dispersion of holdings across the largest banks explains why there is no support for the arguments that banks that are viewed as too-big-to-fail had incentives to have large 39 holdings of such assets. In regressions, we find that bank holdings of highly-rated tranches increase with their asset size, but only up to $50 billion. For banks that have more than $50 billion in assets, those deemed “too-big-to-fail,” their holdings of highly-rated tranches do not significantly increase with asset size.”

In other words, their regressions showed that large banks (>$50 bln) had more toxic assets, and yet, they dismissed this relationship because there happened to be dispersion (as you would expect) among large banks. I fail to see any logic here, and other tests done by ENS suffered from similar problems. The risk management test, for example, used a measure of independence and centrality as a proxy for the quality of risk management. That may sound nice in theory, but it doesn’t even begin to proxy for RM quality, which has to do with the people leading the RM team - their skills, personalities, biases, political aims, degree of “capture” by the business units (same idea as regulatory capture), etc. You can’t use an org chart to measure independence, let alone quality. There were people working in these RM functions who could see that the business was becoming a house of cards (I know some of them), but they also knew their superiors would never deliver that message.

I’m not saying moral hazard was the biggest driver, but there was far more information in Chuck Prince’s “gotta keep dancing” than in this paper. Bankers are well aware that taxpayers have their backs, and that’s a big part of the “gotta keep dancing” mentality. A reasonable question to ask is: would the I-banks have acted as they did if they were still structured as partnerships as in the ‘70s? I doubt it.

"those expecting the Volcker Rule to be a fix-all"

Straw man.

Isn't #8 Obamacare in a nutshell?

I didn't have time to read all the comments, so someone else (who, perhaps, like me, attended GMU and is properly versed in Public Choice Theory) may have mentioned the idea that having smaller banks might be a good idea because it will fragment their voices, and lower their political clout and lobbying ability, and perhaps help reduce the real problem, which is their ability to gain rents and favorable laws through the political process.

Interestingly, the former director of the Center For The Study Of Public Choice didn't mention that. Possibly because the current director of the Mercatus Center knows that such a suggestion skates dangerously close to an idea that isn't part of the donor funded narrative.

#8 Yes, this. We need more conversation about this part of the situation. It seems a legitimate concern that the same forces driving subsidized risky loans are still in play as long as we reform in a direction that fails to clearly signal "dude you should not be borrowing".

The problem is all current banks.

Banks are supposed to be risk-free, so they simply must not be allowed to invest the money at all.

I grew up in the 50s and 60s when Regulation Q was the evil big government jackboot policy villain that was causing all sorts of harm and poverty to humanity.

Basically it represented the requirement that:
1. limited the interest rate charged for debt and paid on deposits
2. required lenders to conform to rules governing verification of income and assets backing any debt
3. set minimum standards for all lending by insured banks whether State or Federal on lending

The claim made by such as Milton Friedman was that deregulating banks would allow individuals to get much higher interest on their bank deposits so they would not be limited to 4% when inflation was 3-4%. That checking accounts would pay 4-5% interest. That individuals would be able to borrow at lower rates with less restrictions on the income and assets they had to have giving them more freedom.

Further, the idea that deposits should be insured only increased costs unnecessarily so money market funds should be able to compete with banks, and money market funds would be managed to insure they never became insolvent - thus no one would ever make a run on money market funds like had happened repeatedly on banks.

And then the Fannie Mae and FHA restrictions on mortgages were far too draconian and harmed the borrowers at too high a cost. The government agency needed to be privatized and given competition because private sector for profit corporations would provide the credit insurance at lower cost and lower risk.

And the banking system would be more stable if the government got out of the way so banking could innovate driven by profit which would ensure low risk to protect share holder profits.

1970 was the tipping point with the beginning of making Fannie Mae go into competition on the path to privately owned for profit. And several other mortgage insurers were started that competed against Fannie Mae with Freddie Mac expanding from its multi-family niche taking over from FHA lending. And money market funds started looking like interest paying checking accounts.

So, has the three decades since 1980 been more stable for banking than the three decades before 1970?

Have interest rates on deposits been significantly higher than inflation since 1980 now that the government does not cap them at 4% and 5%?

Has the cost to the Federal government to insure deposits been lower since 1980 than in the three decades prior to 1970?

Are all individuals getting better bank services at lower costs since 1980 than before 1970 for both deposits and lending?

Given redlining targeted minority communities as government policy, has deregulation resulted in the private sector serving minority communities equally to the middle class white communities since 1980?

Paul Volcker is older than I am by more than a decade, and was more aligned with Milton Friedman than most economists of the time, so he crafted the "Volcker Rule" to try to restore the 50s and 60s banking system without the micro regulation symbolized by Regulation Q.

Can anyone explain why the banking system in the 50s and 60s was significantly worse than the banking system since 1980, or from 2001 to 2008 when virtually all the restrictions on banking of the 50s and 60s were eliminated by Congress repealing them and by Greenspan removing them by Fed deregulation or neglecting to regulate?

Regulation Q was what they still do in Asia: it rations credit, so certain well-heeled creditors, usually the status quo (if a bank has a choice to lend to either an established Fortune 100 company or a start-up, which do you think will get the money?), get subsided (captured) credit. Reg Q was bad, bad, bad and good to get rid of. The real villain here is cheap credit, and the remedy is abolishing all credit subsides, like interest rate deductions and the mortgage deduction, not having even more cheap credit by bringing back Reg Q.

"Can anyone explain why the banking system in the 50s and 60s was significantly worse than the banking system since 1980, or from 2001 to 2008 when virtually all the restrictions on banking of the 50s and 60s were eliminated by Congress repealing them and by Greenspan removing them by Fed deregulation or neglecting to regulate?"

Yes. See a Brookings (hardly right-wing) publication from that era. Carron, The Plight of the Thrift Institutions, includes information on the flight of deposits from Insured Depository Institutions during the late 1960s and the 1970s (before Reagan-era deregulation), and attributes it to the rise of nominal interest rates on safe assets such as 3 month T-bills, which had higher yeilds than the ceiling rate on depository accounts and certificates. By 1980, Brookings estimated that the difference between book value and market value of IDI mortgage portfolios was already over $85 billion. You would get the same story if you read the FDIC's history of itself, The First Fifty years.

One interpretation would be that the reg Q and inflation-influenced nominal interest rates killed the depository institutions. Until someone shopws me a better explanation that conforms with the facts, I will not be a fan of Reg Q and the 1950s/1960s financial regulatory system - unless you can guarantee me there won't be inflation.

Relevant: the always excellent Matt Levine has a good article out today on the Volcker rule.

Why not just restrict the sort of assets a bank can hold, prohibiting a bank from owning futures, options, swaps, derivatives, equities, or loans for the purchase and carrying of securities and at the same time prohibit banks from maintaining a broker-dealer subsidiary?

That would be too simple and cut into the profits of the big money center banks, lol.

Well, I do seem to recall Barney Frank wrote this POS by allowing lobbyists to hold bull sessions in his office.

Cannot help but note that the share of value added in the economy attributable to the financial sector went from 2.8% in 1977 to 5.1% in 2011. Perhaps cutting the profit margins of the money center banks might be part of a salutary rebalancing of our collective portfolio.

No one here has brought up a complaint offered five years ago by Megan McArdle: the Federal Deposit Insurance Corporation has ample history and experience in acting as a receiver for bust deposits-and-loans institutions of a mundane sort. What they've not ever done is attempt to superintend a bank like Citigroup with "a complicated trading book" and most of its deposits domiciled abroad.

And what if that trading book is with an affiliate of the depository institution? The scope of Volcker renders this point off point.

You mean an affiliate which can be severed from the holding company and turned over to a bankruptcy court while FDIC runs the bank?

I am not understanding why it is considered imperative (other than to sate the ambitions of a Vikram Pandit or a James Dimon) to conjoin banks to other sorts of financial enterprises. Is there really that much deadweight loss from compelling loan officers and bond traders to work for different companies? See Luigi Zingales on one point: for reasons of political economy, it is advisable to separate different fractions of the financial sector and increase the possibility that they will lobby political actors at cross purposes to each other.

I am an ignorant layman here, but I seem to recall a good deal of discussion ca. 1988 about "Chinese walls" having to be erected in securities firms. Isn't that an indication that these firms were encompassing functions that belonged in separate firms?

That's a fair point, and I don't have strong views on GLBA and the marrying of commercial and investment banking. It's been said many times before, but WaMu, Lehman, Bear, Goldman, AIG, etc. weren't creatures of GLBA.

But my point is just that much of the discussion of Volcker doesn't reckon with broad scope of the rule (whether with respect to bank affiliates, the covered fund restrictions or the extraterritorial scope), which is odd as it's difficult to conjure up a policy justification for its scope.

And the rule just came across the wire. Fun times ahead.

I understand those institutions were not universal banks, but Citigroup was and Citigroup was a problem for Sheila Bair. So was Bank of America after they chowed down on Merrill, Lynch. IIRC, Citigroup was eventually done in by some sort of option or derivative that Robert Rubin had never heard of ("blah blah blah options put", or something or other). That aside, there was the London Whale.

I am also not understanding why you would have a rule against proprietary trading if you are operating a mutual fund. Isn't having your people trade part of the deal there?

Has anyone worked on an architecture for rapidly liquidating an institution like Lehman? Seems like it went on for years and their creditors got about 15c on the dollar, no? I had the impression that the deal re Dodd-Frank is that you have some board of experts decide which institution to put on life support on a discretionary basis.

The idea is to have very simple regulations, limit the scope and size of the financial entities in ways that are easily understood, and accept the idea that a slightly less efficient structure that is comprehensible and doesn't blow up is a good trade off.

I liked the tone and substance of the post. While I disagree with Cohen that the rule wasn't worth creating, I agree that it does not do much to solve the system's key problem.

Regarding the Volcker Rule Specifically

(1) The final rule does a good job of implementing the statutory language. This is an impressive feat. There was no guarantee that rule makers would be able to craft language that would prevent proprietary trading while allowing hedging and market-making, as the statute requires. I think that this rule accomplishes those things impressively, requiring banks to document that they're trade mitigates risk and that an accumulation of assets is in anticipation of clients' expected needs.

(2) That five agencies were involved in writing this rule is promising, not a bad sign. The regulatory regime over big banks involves each of those agencies, so if the rule is ever going to be enforced consistently, each of these agencies needed to be involved in its writing. The problem is the regulatory structure, which the rule makers couldn't change.

(3) The rule is not pointless. It makes theoretical and practical sense to prevent TBTF banks from engaging in proprietary trading because PT is riskier than other financial activities such as market-making and classic lending.

(4) That said, effective enforcement of the rule will not prevent another financial crisis.

Regarding what is necessary to actually prevent financial crises

The two primary elements of the financial crisis were the (a) inflation and deflation of the asset bubble and (b) the credit crunch sparked by the deflation. Bubbles are inevitable. The VR may mitigate asset bubbles but it won't prevent them. Thus, the primary area ripe for regulation is around the credit-crunch phenomenon. Reform should focus on structuring our financial system such that deflation of an asset bubble doesn't spark a financial panic. We can only accomplish this if we force our biggest financial firms to stop financing long-term lending on short-term credit. The second that fear grips such a system, perhaps sparked by a bubble's deflation but not necessarily so, the "money markets" that finance these firms dry up and the system faces immediate default.

The precedent for this type of reform is the 1933 Act that established the FDIC. In a very real sense, we have a "shadow banking" system that functions the same as the traditional banking system but is not subject to the same regulatory limitations, or benefits, that we have learned are necessary to prevent financial crises.

As Cohen points out, small vs. big isn't the primary problem. A nation full of small banks is also subject to a "collective bank run" that leads to systemic default. We learned in the 1930s that a system of [small] banks financed with uninsured short-term credit (demand deposits - aka 0-term loans) was subject to collective-self destruction. We learned in 2008 that a system of [large] banks financed with short-term credit (e.g. "repo", which are typically 24-hour loans) was also subject to collective-self destruction. It should not have taken a financial crisis to learn this fact. The game-theory analysis on bank runs has long been axiomatic, and the shadow banking system of today is functionally the same as our system pre-1933. Repo financing can dry up just as quickly as demand-deposit financing.

The solution is to prevent big banks from financing themselves with these short-term instruments unless they become subject to the same regulations we apply to FDIC-insured institutions. Once subject to the same restrictions, these institutions can also receive the benefits: the government guaranteeing these short-term financial instruments, thus taking away the risk of a "run" on the firms that rely on them. Paulson and the Fed essentially implement "half" of this system in 2008 by guaranteeing money market mutual funds and directly participating in the repo markets.

If there is a source of major moral hazard in our system today, it stems from the government's arguably implicit guarantee of the "money markets" (equivalent to FDIC insurance) without the regulations to which FDIC-insured banks are subject. On the other hand, it is always possible that this "implicit" garauntee of the money markets will collapse once a crisis hits because of [justified] public anger. If that happens, the next financial crisis really could lead to another depression.

(See generally anything written by Morgan Ricks).

that would prevent proprietary trading while allowing hedging and market-making, as the statute requires

This statement is baffling.

Art Deco: that statement was a bit cursory. As you correctly imply, the statutory language posed a major challenge to rule makers because of the paradox of prohibiting proprietary trading while allowing hedging and market making. Implicit in my statement was that resolving that apparent paradox was a major challenge, but I do think that the rule makers accomplished it. Only time will tell. But by requiring ongoing analysis of why certain hedging strategies mitigate identified risks, and by restricting market-making activity to buying assets that firms reasonably anticipate clients demanding, I think you can protect those functions while eliminating the bulk of proprietary trading activity. That was the purpose of the statute. Whether that actually makes our system any safer is a totally different question.

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