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It’s Time to Just Kill the Volcker Rule

The Board Of Governors Of The Federal Reserve Holds An Open Meeting On Volcker Rule ModificationThe Board Of Governors Of The Federal Reserve Holds An Open Meeting On Volcker Rule Modification
Randal Quarles, vice chairman of supervision at the Federal Reserve, listens during a meeting with the Board of Governors for the Federal Reserve in Washington D.C. on May 30, 2018. Aaron P. Bernstein—Bloomberg via Getty Images

Last week, federal regulators proposed softening the Volcker rule. The nearly 400-page proposal tries to ease the rule’s restrictions on bank trading practices, based largely on bank size. The approach, while rational, is really just an exercise in nibbling around the edges. It would be far better—and simpler—if Congress were to just eliminate the rule completely.

A regulation mandated by Dodd-Frank, the Volcker rule partially bans proprietary trading by banks. The idea behind the rule—a longtime pet project of former Fed Chair Paul Volcker—sounds perfectly sensible: Banks with access to federal deposit insurance and the Fed’s discount window should not be allowed to make risky bets for their own profits.

That idea is flawed, however, because it fails to recognize that U.S. commercial banks make risky bets—with insured funds—for their own profits all the time.

Every single commercial loan is a long-term bet funded with short-term funds, most often composed of at least some federally insured deposits. Each loan is literally a bet that the borrower will make all the rescheduled payments.

If a bank loses the bet, it loses money—thereby risking that it may not have the funds its deposit customers regularly demand. There is nothing inherently safe about traditional commercial banking.

In fact, commercial lending typically creates more liquidity risk than securities trading. Regularly traded securities generally have many buyers, whereas individual commercial loans have no buyers. It is comparatively easy to exit a securities position, whereas it is virtually impossible to sell off a commercial loan that is going south.

Regardless, preventing banks from hedging and making securities trades for their own accounts restricts them to one type of risky financial activity. Even on the surface, this type of restriction is a terrible idea.

If banks adjust their risk-taking behavior in response to the rule, it makes the situation even worse. If, for instance, banks take more risk on their commercial loans in an effort to maintain the profits they expected prior to the Volcker restrictions, then the U.S. will end up with riskier banks.

It makes no sense to prevent these firms from diversifying their risks.

Banks must take risks for profit so that they can continue operating, and forcing them to take only one kind of risk is dangerous. The U.S. has a volatile history with non-diversified financial institutions, and relatively few problems with well-diversified ones.

Even in the 2008 crisis, it was primarily the specialized financial firms—such as Lehman and AIG (AIG)—that got into trouble. The trading desks of large commercial banks had nothing to do with the crash.

History offers no reason to believe that regulators can accurately predict which assets are risky and which are safe.

For example, the Basel capital requirements—another innovation bearing Paul Volcker’s fingerprints—were designed to lower bank capital for assets that regulators deem safer than others. The 2008 crash exposed this scheme as highly flawed precisely because it depends on regulators’ subjective views of risk. The Volcker rule embodies that same flaw.

Not only was the Volcker rule based on flawed theory, its implementation was a complete fiasco for practical reasons. The rule was implemented by five separate regulatory agencies that often disagree on major issues. Moreover, the rule was riddled with all sorts of exemptions.

The latter occurred largely because of banks lobbying for the best possible rule—something that cannot be avoided. However, there is also a major difficulty in distinguishing between proprietary trading and providing trading opportunities for customers (market making). Similarly, it is virtually impossible to distinguish between a legitimate and illegitimate (whatever that means) hedge.

 

The final rule includes exemptions for activities that include “market making, underwriting, hedging, trading in certain government obligations, and organizing and offering a hedge fund or private equity fund, among others.” It may seem odd given all the heated rhetoric surrounding the Volcker rule, but it still allows proprietary trading in U.S. government, agency (Fannie and Freddie), state, and municipal bonds, as well as foreign sovereign debt instruments.

The real irony behind the Volcker rule is that federal regulators had—and used—the authority to regulate proprietary trading ever since Congress passed the 1933 Banking Act, otherwise known as the Glass–Steagall Act. Specifically, section 16 of Glass–Steagall, which Congress did not repeal in 1999, provided the necessary authority.

The Volcker rule has been an enormous waste of time and energy, and it has not made the financial system any safer.

The director of The Heritage Foundation’s Center for Data Analysis, Norbert J. Michel specializes in issues pertaining to financial markets and monetary policy.