The Debate Over the Volcker Rule

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

Matt Levine: If We’re Lucky Volcker Rule Will Make Banks Less Transparent

Tyler Cowen: Is the Volcker rule a good idea?

Today is the day we finally get to see the Volcker Rule… that aims to prevent banks from engaging in speculative trading…. A lot of commentators have been writing posts arguing that the Volcker Rule is either unnecessary or perhaps even counterproductive….

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:

Bank lobbyists think that the Volcker rule is too strict and will sue to weaken it, while anti-bank lobbyists think that it’s too lenient and will lobby to strengthen it…. Opinions, and lawsuits, on whether it’s too strict or not strict enough do not turn on what it actually says.

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.

1. The Volcker rule isn’t a fix-all… and it might not even be… necessary…. Why are we bothering to do this complicated thing?….

The ultimate goal is to build a financial system that helps the real economy while also both preventing… and having the correct tools to deal with crises…. Regulators are creating various tools….

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…. Banks need to be boring again and focus on their core business lines….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.

Is there a way to justify the Volcker rule that is less conceptually terrible than, “well I mean prop trading is less risky than lending but more risky than gardening so we might as well do something”?

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…. First, take resolution authority…. 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….

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….

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…. “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.”

The biggest conceptual objection to the Volcker rule is that its central premise makes no sense. Proprietary trading had basically nothing to do with the financial crisis, and banking is about taking “proprietary” risk with depositor money. This is mostly called “lending,” but calling it “lending” doesn’t make it safer than calling it “prop trading.” The reverse is mostly true.

There is no strong connection between proprietary trading and our recent financial crises. 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.

3. Sure proprietary trading might be dangerous, but so is lending money. In fact, lending money is even more dangerous, given the losses in the crisis, so why don’t you ban banks from doing that too!

The problem there is that lending to households and businesses is the core function of banking. And there are good reasons why banks provide this service…. Other firms can’t easily do what banks do when it comes to lending. But other firms can definitely engage in proprietary trading…. So if proprietary trading does have any benefits to society at large, there’s nothing to worry about. It will still take place. On the other hand, if banks are prohibited from lending, it’s not clear that other institutions could pick up the slack.

If you’re in favor of a strong Volcker rule, cutting down on prop trading risk is a good thing even if that risk isn’t, objectively, especially risky. If you’re against a strong Volcker rule, you’ve been saying “prop trading is less risky than lending” forever and no one has listened to you and they won’t start now or even tomorrow. Unless you sue them, I don’t know.

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”)….

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

4. Allowing banks to have more business lines allows them to diversify their income streams, which will, all things being equal, make the financial system more stable.

Neither theory nor evidence backs up this complaint…. An economic crisis is the result of market-wide risks, and there’s good reason to believe that market-wide risk will go up as banks increase their business lines. That’s why the Volcker Rule is useful…. As Alexis Goldstein notes, “all the gains made by stand-alone prop trading desks from 2006–10 were entirely wiped out by prop trading losses” during the financial crisis. If diversification was a good thing, we would have seen these profits soar during the crisis. Instead, the desks all lost money at the same time, further exacerbating the crisis.

It is impossible to conceptually distinguish “prop trading” from “hedging,” so the Volcker rule will make banks less hedged and more risky.

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.

5. The Volcker Rule will decrease liquidity and available financial services, making the financial sector more vulnerable and less able to meet the needs of the real economy.

This is a concern, but the status quo wasn’t ideal on this front, either. During the last financial crisis, liquidity in the markets disappeared, which shows how vulnerable we are if liquidity is concentrated in a few large banks who have access to the safety net (see Richardson).

The Volcker Rule is designed to allow banks to continue core functions like “market-making” — that is, matching buyers with sellers or acting as an intermediary by using financial instruments. Even so, some liquidity will move to other firms that don’t depend on the banking safety net, creating more competition. This is a perfectly appropriate response.

It is impossible to conceptually distinguish “prop trading” from “market-making,” so the Volcker rule will make market making more difficult and expensive and reduce market liquidity.

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.

6. It is impossible to distinguish between prop trading and the legitimate functions that firms are supposed to be able to still engage in, like market-making and hedging.

This is the correct debate to be having. There are certainly some activities that are clearly considered “proprietary trading,” and banks will be barred from doing these. But there are real questions and gray areas surrounding activities that want to keep banks doing, such as market-making or hedging against risks. As discussed here, we’ll want to keep a close eye on how banks change after the rule is implemented. But the regulators see this as their job and are moving on the task.

Is that a realistic prospect? Will banks revise the documentation and wording of a trade to achieve roughly the economic goal of proprietary trading without calling it “proprietary trading”? Are they banks?…

Well, if banks shift the same activity from “prop trading” to “lending” then, at the margin, they’re shifting from a purely mark-to-market world to one with more scope for avoiding mark-to-market losses. At the margin, they become a bit more opaque. They can hide volatility in lending and available-for-sale activities…

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.

So, rebuilding the core banking sector to be boring and focused on their core business lines, while mitigating systemic risks and enforcing other parts of reform. What’s not to like?

I guess I’ll sidle over to the anti-Volcker-rule side of the mood affiliation. I mostly think the Volcker rule — which will prohibit U.S. banks from engaging in “proprietary trading” but with exemptions for “market-making” and “hedging” — is dumb for all the obvious reasons….

Everybody always wants banks to provide cheap and plentiful credit without taking any risks. If the Volcker rule is another attempt to achieve that fantasy, maybe it’s not all bad.

When I add up all of these factors, I come closer to a “don’t do the Volcker rule” stance in my mind…. 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….

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.