New banking rules in the US, discussing the new Volcker Rule.

There are six big arguments against the Volcker Rule. Here’s why they’re wrong..

exerpt…

Today is the day we finally get to see the Volcker Rule, the new regulation that aims to prevent banks from engaging in speculative trading activity. (See here for an overview.)

Paul Volcker, former chairman of the U.S. Federal Reserve. (Bloomberg)

In all the excitement, a lot of commentators have been writing posts arguing that the Volcker Rule is either unnecessary or perhaps even counterproductive. Both Matt Levine and Tyler Cowen have summed up these cases well.

There are usually six different complaints about the Volcker Rule. By addressing them, we can lay out the case for why this rule is important and worth strengthening. I’ll take the complaints in order from least to most important:

1) “The Volcker rule isn’t a fix-all for Wall Street’s ills, and it might not even be a necessary component of reform. Why are we bothering to do this complicated thing?”

Let’s back up: The Dodd-Frank Act included a series of reforms that were designed to reinforce each other. The ultimate goal is to build a financial system that helps the real economy while also both preventing future crises and having the correct tools to deal with crises when they do happen.

In order to limit the government’s need to act as a safety net during a crisis, regulators are creating various tools that try to do three big things: First, the financial sector will have to internalize some of the costs of crises and insurance. Second, there’s more supervision of banks through things like capital requirements. Third, there are limits on the sorts of activities the banks can do.

The Volcker Rule mainly focuses on the third component — it prevents banks from engaging in “proprietary trading,” which essentially removes the parts of banks that gamble and act like hedge funds, because those parts can blow up quickly (see here for more).

It’s also a conceptual and cultural shift: Banks need to be boring again and focus on their core business lines. As Marcus Stanley of Americans for Financial Reform wrote, the Volcker Rule creates “a new definition of the dealer or market maker role that is more stable and reliable due to the removal of proprietary trading incentives.” This role will still support lending and credit but will also create a new “reliable utility role for dealer banks in the financial markets.”

That’s all just to say that there’s no one single “fix-all” reform here. All three components of financial regulation need to hang together. That involves a well-capitalized banking sector with high leverage, liquidity, and risk-adjusted capital. It also involves a sane over-the-counter derivatives market. And it requires a credible mechanism to force losses on to investors at firms that were previously “Too Big To Fail.” Those components have to work together.

2) “That’s fine, but seriously, this rule would have done nothing useful in solving the last financial crisis. It’s a solution in search of a problem.”

Perhaps. But “solving the last financial crisis” is only one of many goals here. There are other problems that the Volcker Rule does address, at least in part:

First, take resolution authority—the legal regime that’s designed to wind down very large banks and institutions that run into trouble. By preventing banks from engaging in proprietary trading, the Volcker Rule actually makes this task easier. Proprietary trading is notorious for creating quick, large losses, which makes it harder for regulators to deal with failing institutions (resolution authority typically involves nudging banks to better capital while giving regulators the tools necessary to take over failing firms—see more here).

The Volcker Rule also works in concert with other reforms, providing a backstop if those rules don’t work out. If derivatives regulations turn out to be insufficient, for instance, then the Volcker Rule still prevents large banks from carrying out huge bets on tail risk through the derivatives market.

The Volcker Rule would have also helped make the last financial crisis less extreme. “Certainly proprietary positioning played a role in the crisis,” says Caitlin Kline, a former derivatives trader who now works at the non-profit Better Markets. “Banks amassed inventories of high-yielding highly-rated products with largely overnight funding, and this street-wide carry trade helped cause a massive liquidity crisis and then solvency issues, which was a major factor. The Volcker rule will absolutely affect most front-office desk’s ability to warehouse huge positions like that.”

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s