Three Aspects of the Volcker Rule

February 2, 2010

by Chidem Kurdas

Former Federal Reserve chief Paul Volcker and President Obama want to force banks to get rid of their proprietary trading operations, hedge funds and private equity funds. There is more to this policy initiative that meets the eye at first glance.

Mr. Volcker in effect gives two unrelated rationales. One is that “adding further layers of risk to the inherent risks of essential commercial bank functions doesn’t make sense…” So, banish speculative trading to reduce risk.

Put that way, it sounds reasonable enough. The only problem is that it has no real connection to the crisis of 2008 and would almost certainly have no role in preventing  credit cycles, of which the crisis was a manifestation. This irrelevance is presumably why it was not included in the mammoth financial regulation bill making its way around Congress.

Consider the fundamentals. There was an extreme credit and real estate cycle. Markets always cycle, but this one was gigantic because it was fueled by government policy, both the Federal Reserve’s bubble blowing and the encouragement of home buying by Congress, acting through Fannie Mae and Freddie Mac.

When the bust came, it brought down mortgage firms and old-fashioned commercial banks that had given loans secured by property—property prices fell below the value of the loans. Investment banks were caught with securitized mortgage pools, which lost immense amounts when marked to market in the midst of a meltdown where nobody wanted to touch them.  Ironically, now they’ve become popular investments!

All this may have caused losses at bank prop trading desks, hedge funds and private equity funds, but those were minor compared to the losses from real estate-related securitization operations and loans. Plus, outside investors took most of the hit. If Bear Stearns had sustained losses only in its two hedge funds, it would have had a reasonable chance of surviving.

Now, there is an entirely different reason to break these activities from banks, which Volcker trots out without making a distinction from the “avoid additional layers of risk” argument. An investment bank’s own traders might take advantage of the knowledge within the company of what the brokerage customers are doing. Traders complain that bank prop desks have an unfair advantage. There is a potential conflict of interest.

Volcker says “curbing the proprietary interests of commercial banks is in the interest of fair and open competition…

This issue has been around for many years and has no bearing on crisis-causing risk.  Traders have the option of going to a brokerage that does not trade on its own—indeed, there are brokers who use not trading as their selling point.

By Volcker’s own admission, prop trading by banks is not widespread. He writes that “only a handful of American mega-commercial banks, perhaps four or five” engage in the speculative activities. Moreover, the revenue derived from trading is a small component of total revenue. Goldman Sachs, the big player, gets 7% of its annual revenue from the activity, which accounts for only 1% to 3% of other banks’ revenues.

Nevertheless, some folks would make a great deal of money if they took over the lucrative trading business, say, of Goldman.  It is hard not to suspect that an interest group must be lobbying behind the scenes to include a ban on prop trading in the financial regulation bill. The two rationales given by Volcker – avoiding additional risk and potential conflict of interest – are the presentable reasons.

But there is also a less respectable effect: any such measure will re-distribute profit opportunities. This third aspect is the one you don’t hear about.

22 Responses to “Three Aspects of the Volcker Rule”


  1. When it comes to bank reform, the perfect will always be the enemy of the good. So do we do soemthing, or nothing? We know where doing nothing will end up; only the timing is in doubt.

    It is the handful of big banks that constitute the greatest problem. “Too-big-to fail is about them.

    I don’t trust the numbers being peddled on proprietary trading. You don’t make GS style profits “making markets” (however the hell that is defined).

    Proprietary trading amounts to operating a hedge fund within fund in a bank. Government backing of banks means the activity is subsidized and there will be too much of it and it will be too risky (moral hazard).

    So Volcker is proposing that if an institution takes insured deposits and has other gov’t. guarantees, it can’t engage in proprietary trading.

    It’s a nice start.

  2. chidemkurdas Says:

    Yes Jerry, the perfect is the enemy of the good, but on the other hand, as in medicine, the rule in policy making should be to do no harm. This will affect only a small number of firms (by Volcker’s own reckoning)but it is yet another step in substituting government command for market process.

  3. chidemkurdas Says:

    Goldman & Morgan Stanley are not even depository banks. Of the big names, I believe only Citigroup and Bank of America combine deposit taking with investment banking, and the latter mainly because it acquired Merrill Lynch–under government duress, you may recall.

  4. chidemkurdas Says:

    Here’s a report from Davos, showing the interests involved:
    “By the way, some private equity executives were thrilled about the Volcker Rule because it would mean commercial banks could no longer compete with them.” http://www.nytimes.com/2010/02/02/business/02sorkin.html

  5. chidemkurdas Says:

    I just realized there’s an excellent post on this by Mark Calabria
    http://www.cato-at-liberty.org/2010/02/02/volcker-rule-misses-the-mark/


  6. Chidem,

    I’m sorry, but you can’t apply laissez-faire arguments to corporatist economic arrangements. Doing nothing is not doing no harm; it ensures another banking crisis. Doing nothing means the large banks remain protected and sustained by the taxpayer.

    I side with Allan Meltzer on this issue. There is no conceivable efficiency gain that justifies the risk these gigantic, risky institutions impose on all of us.

    Every single one of the major investment banks, including GS, became BHCs and come under Fed supervision. You’re wrong about that. Whether they presently collect deposits, they have the Fed’s largesse under 13(3) of the F.R. Act (emergency lending).

    Volcker has been very clear, and correctly so, that he does not care if hedge funds and private equity operations engage in highly risky activities. He wants them off the public dole. Do you prefer them on the dole?

    And to anticipate the next argument: I don’t care if Goldman or Citi or whoever threatens to redomicile in another country. I’m prepared to go down to the pier and wish them bon vogage as they sail away. Let the taxpayers of some other country take on their liabilities.

    (Not that I think any country wants to take on any more of these problems.)

  7. Current Says:

    Limiting the activities of institutions that are subsidised by government gaurantees is good.

    But, what worries me is that it’s not clearly being done for that reason. Though Volcker seems clearer than lots of others.

    It worries me that the arguments for these limitations may be seen to have been proven if they work. Those arguments may then be used to implement needless limitations in the future.

  8. chidemkurdas Says:

    Jerry, this is a bit like saying,the patient has a fever, we have no idea what to do, but why don’t we put on some leeches for blood letting. It will not prevent crises or solve the banks-on-the-dole problem. It was not the prop desks that required bailouts.

    Volcker argues that deposit-taking banks should not take extra risks with trading. But the investment banks with big prop desks are not currently taking deposits. Their legal status as bank holding companies may entail federal largess, but no deposits are endangered. You’re implying that the Feds will have to step in anyway to cover trading losses.

    The solution is obvious: the government should not do any such thing.


  9. I agree with Current on the risks. The arguments have been made in many places, including here and other blogs.

    Volcker had been cut out of decisionmaking until late in the game.


  10. We do know what the problem is — government subsidized risk-taking that creates moral hazard.
    The government activly interferes in financial markets in support of all banks (generically), and particularly the largest.

    Deposit insurance is not the primary benefit for the very largest banks. Too-big-to fail support is the primary benefit, with all the subsidized lending, capital support and and access to the Fed.

    I ceratinly think there are many other problems to tackle besides proprietary trading. The derivative, CDO and swap activities of banks are also problematic.

    But prop trading is what is on the table and is straightforward to tackle (despite obfuscation being generated around it). The fact that a policy doesn’t solve all problems is not an argument against it.

    I have seen a lot of claims that the investment banks didn’t take deposits. But most did have despository subs — often thrifts. Merrill, Lehman and Morgan all did and were taking deposits. AIG had thrift powers because it was using a thrift to write all those derivative contracts.

    So the bottom line, is that you want to continue to subsidize risk taking and create moral hazard in the financial services industry. On that you are clear.

  11. Walker Todd Says:

    I am pleased to support all of Jerry’s comments and more.
    You fellows and ladies need to look up Jack Willoughby’s excellent piece on the Goldman acquisition of the main specialist firms on the NYSE (esp. Spear Leeds Kellogg)a few years ago and compare it with more recent revelations (last six months or so) on “high frequency trading.” I think Jack’s article was in Barrons.
    Here’s the bottom line: If I’m Goldman and I own the specialists on the exchange floor, then I happen to know the underlying bid in the market ahead of the exchange itself. You have to have a powerful and redeeming faith in Chinese walls to believe that the “informed specialist” never ever (well, hardly ever) would allow that “inside” information to trickle across the wall. In market parlance, a firm that both handled customer accounts and traded for its own account and engaged in high frequency trading and owned the specialists would have the capacity (but surely not the will!) to engage in “frontrunning” (trading for its own account ahead of customers, which supposedly is prohibited by the SEC and the exchange rules).

    Back to Volcker: In this case, the idol has feet of clay that extend to the thigh zone. But the leading alternative candidates have feet of clay running up to the neck or the eyeballs.

    Think of what it means when (a) you’re the biggest kid on the block, (b) you own all the important specialist (market-maker) firms on the floor of the exchange, (c) you engage in high-frequency trading, and (d) you have only the flimsiest of Chinese walls keeping your proprietary trading operation from access to the information to which (b) is privy even ahead of the exchange’s own computers. There is no safety and soundness concern about this arrangement, but there surely is a bit of potential for morally abhorrent behavior.

    Volcker says, essentially, let’s not align the dominos so that the aforementioned scenario occurs. Chidem’s view seems to be, “So what if it occurs.” My response is, this is the price you have to pay (restoration of Glass-Steagall) to bring credibility, public support, and (heaven forfend) a bit of moral tone to the market.

    In choosing between a world designed by Montesquieu, with checks and balances, and a world designed by Macchiavelli, with no moral order at the core, most people in the United States would prefer the Montesquieu version, which is in fact the version guaranteed to them by the Constitution. A world where “What can I get away with?” is the dominant concern is one that will have a short half-life. — Walker Todd

  12. chidemkurdas Says:

    Hi Walker. Last time we talked, I think I was interviewing you about agricultural futures markets for Futures Intelligence. Nice to encounter you on ThinkMarkets. It’s a small world!

    The problem of conflict of interest with brokerage customers, including the possibility of front running etc. that you mention, is an entirely issue from the risk taking-moral hazard question that Jerry is advocating as the reason for imposing these restrictions. Conflict of interest allegations have been around for years. As I mentioned, there are brokers that use their not having trading operations as advertising for their services.

    If that were the reason for the rule, then evidence should be presented that front running is happening and prop trading banned on that basis. That has nothing to do with the main reason Volcker, Obama and other proponents are pushing for the rule–namely that government backup for big banks requires that they be kept from taking risks.

    The conflict-of-interest rationale is based on prop desks making too much money–by front running. The risk-moral hazard rationale is based on the possibility of their making losses that the government will then take on.

    Why have such divergent reasons for doing this? What’s the real reason?

  13. chidemkurdas Says:

    AS for checks and balances, indeed, the makers of the constitution worked very hard to put limits on government power. The notion of a government that does whatever it pleases, under murky pretenses, certainly violates their goal of limited power. That argument is against you.

  14. chidemkurdas Says:

    Jerry, re subsidies to risk taking, whether on prop desks or elsewhere, I can only repeat what I already wrote: the government should do no such thing. It is bizarre that government bailouts are simply taken as a given in this debate. In fact another piece of proposed bank regulation is to liquidate/sell all insolvent financial institutions, as is done with commercial banks–Volcker himself talks about this. That process is not a bailout and no bank executive will want to be subject to it.


  15. Chidem,

    “The government should do no such thing.”

    That is not a response to the question (which is Volcker’s and mine): what do we do in world in which government bailouts of “too-big-to fail” institutions are the rule of the day? It’s not an assumption, but a fact.

    In that world, opposing all policies to reign in moral hazrad and risk taking is objectively to favor their continuation. The law of excluded middle provides no third choice.

    But play your games. I’m just not going to waste my time responding to you in the future.

  16. chidemkurdas Says:

    Jerry, I like reading your comments, they’re very informative. Nevertheless, it is not clear to me why you would take the bad precedent that was set in 2008, in the midst of the worst crisis in decades, as carved in stone. An orderly winding down of any financial business that becomes insolvent makes a lot more sense than putting it on the dole! You take it as given that there is no way to prevent future bailouts, hence the industry has to be re-made on that premise.

    Maybe that will turn out to be the case, but it seems unwarranted to accept it without seeking alternatives.

  17. chidemkurdas Says:

    Also, if we were to accept your argument, it would make more sense to impose Glass-Steagall wholesale than focus on just prop trading, hedge funds and private equity. By separating investment banking altogether from depository banks, at least some of the activities that did lead to bailouts would be cordoned off. That said, Glass-Steagall would have made no difference for the really bad disasters, namely AIG, Fannie and Freddie.

  18. Pete Says:

    One thing is certain, neither Obama or Volcker have the slightest idea what is going on. Both are profoundly ignorant of what goes on in these banks the propose to regulate. Further, the “prop desks” were not the issue. Most of the losses were mortgage related losses. Prop trading, particularly for Goldman has been hugely profitable.

    The obvious answer is to curtail the ability of the Fed and the FDIC to backstop depository institutions. There are many solutions. Reducing FDIC insurance to 25k per person could be a start. Oddly enough, there has been very little risk in non-fdic insured money market funds.

    Say what you want about the need for bank reform, one thing is certain, you won’t be getting anything good.

  19. chidemkurdas Says:

    Pete, that is the crux of the matter. However, Jerry has a point that given the extensive bailouts of the past two year — not only in the financial industry, witness GM and Chrysler — it will be very difficult to establish a credible restriction on future bailouts.

    The best bet probably is to establish a quick and orderly process for unwinding any insolvent financial institution. The main reason bankruptcies cause so much damage is that they take a long time and the assets are tied up for years, as has happened with Lehman Brothers.


  20. [...] gain that justifies the risk these gigantic, risky institutions impose on all of us,” to quote one of his comments. The main argument is that large banks, having been given access to financing from the Fed during [...]


  21. [...] that justifies a risk these gigantic, unsure institutions levy on all of us,” to quote one of his comments. The categorical evidence is that vast banks, carrying been given entrance to financing from a Fed [...]


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