We Americans love a comeback story. Cyclist Lance Armstrong, it turns out, may have had a bit of chemical help on the hills, but Tall Paul Volcker climbed back to the pinnacle of public policy on the strength of his unadulterated reputation for monetary wisdom and integrity (and perhaps a wee boost from the Massachusetts by-election).
With financial regulatory reform seemingly in ruins early in the year, the so-called Volcker Rule quickly emerged as its resurgent centrepiece. Now it is law. Comeback complete.
So what exactly is the Volcker Rule? The lawyers can't yet tell us, as the mammoth reform legislation passed by Congress in July kicked that can over to the regulators. But we do know its essence: that institutions which take government-backed deposits should not engage in proprietary trading. Given that the financial crisis owed much to reckless speculative behaviour, surely this is prudent and necessary.
Or is it?
Even to ask the question risks putting oneself in the same camp as loony libertarians, still refusing to acknowledge that unfettered financial markets inevitably get us into economic catastrophe. Yet when it comes to financial regulation, the devil is truly in the detail. And it is in the details where the Volcker Rule will inevitably run into trouble.
Consider the disturbing fact that if we rewound this film to, say, 2000, plugged in a Volcker Rule, and ran it again, the crisis would have turned out exactly the same. Bear Stearns would have failed. Lehman would have failed. AIG would have failed. These were not failures caused by speculation with insured deposits. This observation alone should have been sufficient, in my view, to relegate the Volcker Rule to the fringes of the financial reform effort.
The natural objection to this line of reasoning is that the next crisis won't roll around precisely the same way as the last one. But we do know, this argument goes, that government backstops, whether in the form of implicit guarantees for Fannie and Freddie debt, or explicit guarantees like FDIC deposit insurance, encourage financial institutions to take excessive risks. So we need to ring-fence the part of the financial sector that benefits from such guarantees, and restrict its ability to gamble. The Volcker Rule is part of this necessary ring-fencing.
The problem with this argument is that Goldman Sachs and Morgan Stanley were outside this ring fence before the crisis, and were only brought within it by the government after they got themselves into trouble. The government transformed them into bank holding companies in 2008 in order to give them guarantees and liquidity access benefits that Volcker wants to make sure they cannot have so long as they're engaged in prop trading. But if the government is going to create privileged, insured deposit-taking institutions out of prop shops in the midst of a crisis, the Volcker Rule is hopelessly chasing a moving target.
Finally, and most subversively, I would ask whether proprietary trading is really all that risky. All lending or investing of customer deposits is risky – it is only a question of degree. So ask yourself: in the absence of deposit insurance, would you prefer to deposit your money with Goldman Sachs, knowing that it will use it to buy and sell securities, or a small Midwestern bank that will lend it out to fund commercial real estate punts? I'd take my chances with Goldman.
To frame the problem in financial economic terms, traditional banking is inherently risky precisely because of the maturity transformation that takes place in the process of turning short-term liquid deposits into long-term illiquid loans. If the depositors demand too much of their money back too quickly, the bank goes bust. Yet no such maturity transformation typically takes place in the case of prop trading: a financial institution can liquidate securities positions to satisfy deposit withdrawals much more quickly and reliably than it can liquidate commercial real estate loans. In short, prop trading involves a low level of maturity mismatch, and is therefore, along this dimension at least, considerably less risky than traditional lending.
The Volcker Rule is a species – though not a particularly robust one – of so-called narrow banking: protecting deposits by limiting deposit-taking institutions to holding safe, liquid assets. Narrow banking addresses the incentives the suppliers of insured deposit accounts have to take outsized risks. But it ignores the demand side. As the risk of the banks' assets comes down, so does their return.
The government can reduce the risk of banks' deposit-funded assets to virtually zero by making them hold 100% cash in reserve, but this will also reduce the rate the banks can pay on deposits to zero (actually less than zero, given that banks must cover their costs). The zero return will push savers out of bank deposits and into other investment vehicles, which will then supplant the banks as providers of credit to industry.
Volcker, who has long been a sceptic on the benefits of securitisation, clearly had no intention of pushing companies away from bank financing and towards more securitised credit. But that is the direction in which all narrow banking proposals take us.
The bottom line is that the Volcker Rule will neither make insured deposits safer nor reduce the risk of future financial crises.
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