Bank Regulatory Blog

THE VOLCKER RULE – WHAT IT IS AND WHAT IT SHOULD BE

Posted February 4, 2010

Author: Cory D. Childs

Last week, President Obama announced a proposed rule aimed at separating banks from certain securities activities.  He dubbed the proposal the “Volcker Rule” after Paul Volcker, the Economic Recovery Advisory Board Chairman and former Federal Reserve Chairman who endorses the rule.  The proposal would prevent commercial banks from owning or investing in hedge funds and private equity funds.  The rule would also limit banks from trading for their own accounts, a practice referred to as “proprietary trading.”  Basically, the proposal would restrict a bank’s ability to engage in speculative investing for its own personal gain.

Here’s the full quote from Obama’s announcement:

It’s for these reasons that I’m proposing a simple and common-sense reform, which we’re calling the “Volcker Rule” — after this tall guy behind me.  Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.  If financial firms want to trade for profit, that’s something they’re free to do.  Indeed, doing so – responsibly – is a good thing for the markets and the economy.  But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.

The Volcker Rule presents President Obama an opportunity to show Main Street that he is toughening his stance on Wall Street.  He argues that risky investing by investment banks such as Goldman Sachs and Morgan Stanley played a significant role in the recent financial crisis.  The rule attempts to punish these institutions by eliminating revenues derived from speculative investing.  Austan Goolsbee, a White House economist, put it more succinctly in a Wall Street Journal article when he stated, “the key issue is that institutions that are getting a backstop from the taxpayer shouldn’t be able to make a profit off their own investing.”

Clearly, some action needs to be taken to ensure that we do not face another financial meltdown.  But the problem with the Volcker Rule is its unintended consequences.  In his address to the Senate Banking Committee on February 2, 2010, Mr. Volcker argued for complete separation of commercial banks from financial markets.  A rule like this that would not allow a commercial bank to speculate in capital markets would immediately affect bank profits, at least in the short run.  Recently, investment banks have tended to make less money at banking and more money at investing.  Suddenly illegalizing investing at institutions that also own banks would eliminate this main source of revenue, which could have a domino effect on the rest of the economy.  Once revenues in this area are lost, banks would actually take less risk on the banking side by tightening lending practices.  If companies can’t borrow, they don’t spend.  If companies don’t spend, then they don’t hire.  If people don’t get hired, then they don’t spend either.  Of course, less spending halts the economy, which leads directly to worldwide chaos.

Now maybe that’s an exaggeration.

But not really.

So what should the Volcker Rule actually do to achieve the President’s goals?  First, I agree with the part of the proposal that would separate hedge funds from banks.  As a former hedge fund manager, I can tell you that combining a hedge fund and a bank is a bad idea.  Hedge fund managers are paid to take risks.  The more risks they take, the more fees they generate.  Taking risks is not necessarily a bad thing.  However, in this context, it could lead to an unfortunate outcome. 

For example, consider a stand-alone hedge fund, completely detached from a bank or other large institution.  That manager would be more reluctant to take extraordinary risks because once the money is gone, both the manager and the fund itself soon follow. 

Now consider the hedge fund bankrolled (literally) by a large bank, such as Wells Fargo or Bank of America.  This manager has an incentive to take extraordinary risks and may even be encouraged to do so.  If these extraordinary risks do not pay off, the fund has an entire bank’s assets at its disposal to replace the blown investment.  In normal economic times, this would not necessarily be a problem either.  Except these are not normal economic times and our hypothetical bank’s assets in this case have been subsidized by taxpayer dollars.  (See any one of the eight million articles written about the “Bank Bailout” on Google.)  Separating hedge funds from banks ensures that the entire risk of any speculative investing is borne solely by the hedge fund itself and not by banks and, subsequently, by taxpayers.  Mr. Volcker agreed with this sentiment in his Senate testimony stating:  “Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depositary institutions.”

Once the hedge funds are removed, the question becomes how far should proprietary trading be curbed in banks.  Again, this type of investing, if profitable, may give banks more cash to lend to customers, which reverses the domino effect discussed above.  However, if the speculation that can occur by proprietary traders is not checked in some meaningful way, then we are right back to where we started.  But cutting off this entire revenue stream would go too far.  Instead of wholly eliminating this practice in banks, the President would be better served by merely regulating the activity.  One solution would be to limit the amount of assets that a bank can invest.  This solution would allow banks to maintain this stream of revenue while ensuring that their speculation does not get out of hand.  Treasury Secretary Timothy Geithner backs this solution despite his vocal support for the Volcker Rule.  In his testimony before Congress, Mr. Geithner stated that banks “should be subjected to a set of constraints on capital, on leverage and how you are funded that limit the amount of risks you take.” 

A second solution would be to require banks investing in speculative assets to increase their capital reserve to cover any potential losses.  This solution would also effectively lower the total assets that the bank has to invest in speculative ventures.  A bank that has a limited amount of assets to invest will invest those assets more wisely. 

With these solutions, everyone wins.  The President gets to appear tough on Wall Street.  Banks get to continue receiving this revenue stream.  And bank customers are free to borrow and spend, resurrecting the economy, which leads directly to worldwide harmony.

Now maybe that’s an exaggeration. 

But not really.

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