Paul Volcker is a man of considerable stature, and not just because he’s six feet, seven inches tall. He gained a reputation for courage and plain talk as chairman of the Federal Reserve System under Presidents Carter and Reagan because he broke the back of the 1970s inflation. He did so by (mostly) sticking to a tight monetary policy even though that meant sky-high interest rates and sharp back-to-back recessions before the economy could enter its vigorous recovery. Now 84, he has enjoyed a comeback in recent years as an adviser to President Obama. His Volcker Rule, prohibiting proprietary trading by banks, was heralded as one way of preventing a repeat of the recent financial crisis, and it became part of the Dodd-Frank Act signed into law in July 2010.
Dodd-Frank’s full title, incidentally, is the Wall Street Reform and Consumer Protection Act. Like most current legislation its name reflects hoped-for outcomes, not its actual provisions. Reading the act (the PDF is available here) is not for the faint of heart. There are 16 titles consisting of 1,601 sections for a total of 848 dense pages. Only a lawyer could love sentences like this:
Any nonbank financial company supervised by the Board that engages in proprietary trading or takes or retains any equity, partnership, or other ownership interest in or sponsors a hedge fund or a private equity fund shall be subject, by rule, as provided in subsection (b)(2), to additional capital requirements for and additional quantitative limits with regards to such proprietary trading and taking or retaining any equity, partnership, or other ownership interest in or sponsorship of a hedge fund or a private equity fund, except that permitted activities as described in subsection (d) shall not be subject to the additional capital and additional quantitative limits except as provided in subsection (d)(3), as if the nonbank financial company supervised by the Board were a banking entity.
Volcker initially outlined his proposal in a three-page memorandum. It came to life as Section 619 of Dodd-Frank, expanded to 11 dense pages. This section is supposed to prevent banks from buying and selling securities for their own accounts, in contrast to brokering customer trades. It also prohibits banks from holding interests in hedge funds or private equity funds or from sponsoring such funds. These prohibitions are supposed to lessen the need for future bailouts like those that were provided to financial institutions in 2008 and 2009.
But Volcker is not happy. “I don’t like it, but there it is,” he said. “I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance.” On the other hand Rep. Frank, former Sen. Dodd, President Obama, and all the other Dodd-Frank sponsors should be happy. They achieved their purposes when the act was signed. They can now boast of having tamed the Wall Street beast so that the little people will never again be stuck with a bill for bailouts. But the full effects of Dodd-Frank won’t be felt until after this year’s election because so much depends on how the bureaucracy makes the rules that give meaning to the act. Exaggerating just a bit, one wag called Dodd-Frank a blank piece of paper for rule-makers to write on.
Four federal regulatory agencies are charged with writing the Volcker rules. Those agencies are supposed to play nice with one another—a 94-word sentence on page 247 orders them to do so. But a squabble has already broken out between the Fed and the Federal Deposit Insurance Corporation. Recently Bank of America moved some derivatives from its Merrill Lynch subsidiary to a subsidiary that holds insured deposits. The Fed favored this move as a way of providing relief to the bank’s holding company, while the FDIC, which would have to pay off depositors in the event of a failure, objected.
Last October the four agencies issued a tentative set of rules extending to 298 pages, inviting public responses to about 400 questions. A sample: “Should the Agencies use a gradual, phased in approach to implement the statute rather than having the implementing rules become effective at one time? If so, what prohibitions and restrictions should be implemented first? Please explain.” This is a pretty basic question, suggesting that regulators are in over their heads and are trying to get private parties to rescue them. This would be no surprise given their daunting task plus the fact that the smartest financial people can make a lot more money on Wall Street than they can working for regulatory agencies.
The draft rules are full of exemptions, which caught the attention of Ted Kaufman, former senator from Delaware and now a Duke University Law School professor. “We’ve been through this before,” he said. “I know these folks, these Wall Street guys. . . . [T]hey’re smart as hell. You give them the smallest little hole and they’ll run through it.”
Loopholes and Ambiguity
Why the exemptions? Have the bankers bullied the regulators into line? Maybe, but the rule writers seem to recognize that proprietary trading isn’t so easy to recognize and may not always be a bad thing. Prop trading can actually help keep markets running smoothly by providing liquidity. The exemptions fall into several broad categories that are fraught with loopholes and ambiguity.
First, trading on behalf of customers is exempt. But when a firm seeks a buyer for a customer’s securities, it may have possession of those securities for some period of time, during which it is exposed to market risk just as if it were conducting proprietary trading. How long must these intervals become before the transaction becomes a proprietary trade? If the regulators tried to pin this down they would very likely suppress some perfectly good trades while letting others through that really should be called proprietary. A big ambiguity here.
Hedging is also exempt. This is the practice of taking a secondary position to offset the risk of another investment. For example, if I expect to receive a million euros next year but fear that the euro will decline before I get paid, I can hedge by entering a contract obligating me to deliver a million euros next year at an exchange rate agreed on today. But sometimes hedges only partially offset a particular risk. Hedges are another big ambiguity in the rules.
Underwriting and market-making are exempt. A firm that makes a market for some security usually carries an inventory of it, and that means risk. It is entirely possible that a firm could label an asset as inventory for its market-making operation when in fact its real motivation is speculation for its own account. Motives can be elusive.
Finally, the feds have issued a blanket exemption for proprietary trading of their own securities. No surprise here. We all know that Treasury securities are free of risk—or are they? If you buy a ten-year bond yielding 1.8 percent and then two years later the rate for such bonds rises to a more normal 3 percent, your bond’s market value will decline by nearly one-fifth. If you had borrowed 80 percent of the bond’s price, you would have lost all your equity. Trading Treasury bonds, even if considered free of default risk, can be risky in terms of market price.
Rule makers accepted comments through January 2012 and have until July to finish the rules. They may well miss that deadline, but Dodd-Frank will take effect all the same. Then nobody will really be sure of what it means. Business uncertainty will increase, and prospects for robust economic recovery will dim.
Obama recently said that “of course” there had been too little regulation during the recent financial crisis. Really? Notwithstanding some deregulation in recent years, banking and finance remain more heavily regulated than almost any other industry. Such deregulatory changes as we have had, like the opening of interstate banking, have been overwhelmingly beneficial and are not the source of the recent financial crisis. (See “The Rise and Fall of Glass-Steagall”) Problems in the financial system will not be solved by piling on more layers of regulation. Better qualified or more dedicated regulators, if such could be found, can’t do it either.
Should we get rid of all regulation? In its broadest sense, to regulate an activity simply means to make it regular and orderly. Regulation by government agencies will always be problematic. For one thing, as Kaufman observed, those who are subject to government regulation will find ways around the rules, and the result is invariably a call for yet another layer of regulations. Government regulators, no matter how well-intentioned, cannot possibly acquire the detailed knowledge of dozens or hundreds of individual firms. They usually have no choice but to rely on those managers, as shown by the question quoted above. If their relationship is at all cordial, the regulators tend, perhaps unconsciously, to take on the perspective of the regulated firms rather than the customers they are supposed to protect. This is called “regulatory capture.”
Can greedy managers be trusted to regulate themselves? First, greed is nothing new, and it’s not going away. Second, the question implies that managers must be trusted to walk a narrow path and avert their eyes from temptation. This is a false alternative. In fact free-market institutions, if allowed to operate, will “regulate” greedy managers more strictly and more effectively than government agents can. Free markets offer long-term rewards to those who earn the trust of customers while keeping managers focused on the fear of failure.
We have to emphasize that markets must operate in a proper legal framework, one that does not tolerate theft or fraud. These activities must always be sanctioned and, when uncovered, be met with restitution and punishment.
So without the Volcker Rule or similar regulations, what would stop bank managers from dumping risky assets into government-insured banks? In a free market there wouldn’t be government deposit insurance. There might be private insurance, but the providers would be powerfully motivated to ride herd on the insured. Bank managers, with or without insurance, would have to earn depositors’ trust. And depositors would have to pay attention to the soundness of the banks they patronize. How can ordinary individuals judge the soundness of institutions as complex as banks? The same way we judge the quality of all kinds of providers these days: by looking online for five-star ratings.
Without government deposit insurance, might bank failures sometimes result in depositor losses? Yes! Occasional failures would put the fear of God into managers and depositors alike. Customers who would avoid risk altogether could seek pure custodial banks rather than loan banks. But then they shouldn’t expect free checking or free ATMs. At the same time, customers seeking high returns and willing to accept the necessary risk would be happy to see their funds deployed in assets like the derivatives that Bank of America recently moved. Perhaps such risk-taking institutions would no longer be called banks.
“Creative destruction” sounds harsh, and indeed it can be. But the benefits of free markets cannot be had without the possibility of failure, and in the end, failures are benefits too.
A dramatic tale of failure has unfolded before our eyes just now: MF Global declared bankruptcy last October. There are allegations that the firm misappropriated customer funds, a serious charge that has not been resolved at this writing. We are not concerned here with any criminal behavior but rather MF’s errors of judgment and the fate of its shareholders and creditors.
This publicly held firm was headed by John Corzine, former boss of Goldman Sachs, former governor of New Jersey, and a former U.S. senator. MF traded sophisticated securities, such as futures and options, both for its own accounts and on behalf of clients. On taking the reins of MF Global, Corzine decided the firm should assume more risk, and never mind the 2008 collapse, which had sobered most financial managers. The firm bet heavily and wrongly on European sovereign debt securities and paid with its corporate life. MF was engaged in risky proprietary trading, but because it was not a bank, it would have been exempt from Dodd-Frank’s Volcker provisions even if they had been in effect. MF Global’s missteps provide a textbook illustration of what should happen when a firm conducts unwise proprietary trading or any other sort of excessive risk. No trading prohibitions were necessary, and the consequences of management’s errors fell just where they should. Shareholders were wiped out, management is unemployed, and creditors will line up in bankruptcy court.
Notwithstanding the MF story there is little cause to hope for a turn to market regulation any time soon. The rules will be written, Dodd-Frank will take effect, and new crises will arise. More legislation will be proposed and the cycle will repeat.
[Editor's note: this essay first appeared in the Freeman on Feb 23 2012]