Regulators Mull Changes to ‘Volcker Rule’ on Bank Investments

Last week, the Office of the Comptroller of the Currency (OCC) announced that it will seek public comment on how to improve the Volcker Rule, a Dodd-Frank provision named after former Federal Reserve Chairman Paul Volcker. Controversial from its inception, both the Trump administration and congressional Republicans have sought to strip back the regulation, whether through executive agencies, such as the OCC, easing its enforcement or Congress abolishing it altogether.

Given that the Volcker Rule’s future hangs in the balance, it is important to review its short history, perverse effects, and what the best options are for its reform.   

A Brief History

The Volcker Rule was established under Section 619 of the Dodd–Frank Wall Street Reform and Consumer Protection Act. Implemented in 2015, the nearly 1,000-page regulation took 5 different federal agencies over 3 years to write. That is a lot of regulatory man-power for a rule that looks to essentially do two things: prohibit commercial banks from engaging in 1) certain types of proprietary trading and 2) investing in hedge funds or private equity funds.

Proprietary trading, or “prop trading,” as it is known, is where a firm uses its own capital and balance sheet to make short-term trades for its own profit. Firms may prefer this kind of trading as it allows them to realize all the gains from an investment, as opposed to earning thin-margin commissions when trading on behalf of clients.

But there are other functions of prop trading, too, which are widely recognized as vital to the function of the financial system. This is why the Volcker Rule looks to exempt certain kinds of trading activities, such as market making (investing in trading securities for their own account, to facilitate potential future trades) or hedging activities (investing in trading securities for their own account, to mitigate their risks elsewhere), as well as trading in government securities.

What the Volcker Rule is trying to target, therefore, is what critics refer to as “gambling” of federally insured depositor’s money purely for a bank’s own gain. It purports to do this by separating certain activities of commercial and investment banks. Supporters often claim that this is a justified response to the 2007-08 financial crisis, which they blamed on Wall Street’s “reckless behavior” in dealing in complex financial products.

The problem is, however, that proprietary trading is more than just “reckless gambling,” and it had nothing to do with causing the financial crisis. If anything, it made the crisis less severe by shoring up liquidity for struggling banks. The Volcker Rule was rather a mistaken and unnecessary response to the wrong problem. Instead, targeting certain trading activities has led to reduced liquidity and a less stable financial system—exactly the opposite of what the rule was intended to do.

Universal Banking and the Financial Crisis

Universal banking, the mix of commercial and investment services, is the common whipping boy of the financial crisis. But it shouldn’t be. Separating the two, by instituting the Glass-Steagall Act or the Volcker Rule, would have done exactly nothing to stop the crisis.

In fact, it was precisely those institutions that were completely separated that found themselves in trouble. The investment banks that failed, such as Bear Stearns and Lehman Brothers, had no commercial banking arms. They could not use federally insured deposits to make speculative bets. On the other hand, the commercial banks that failed did so because of sub-prime mortgage lending, not proprietary trading.

Moreover, the overall share of loan losses was greater than the overall share of trading losses. The crisis was, evidently, not one based on risky trading. The value of mortgage-backed securities did not crash because they were traded, but because the mortgages that backed those securities had become worthless. It would make as much sense to argue that banks should stop lending to protect depositors as it does for banks to stop trading to protect depositors.

As CEI Senior Fellow John Berlau has written:

There is no evidence that proprietary trading…is more dangerous than executing trades for customers. In the leadup to the financial crisis, banks traded mortgage-backed securities for themselves and for their customers, but at bottom the instruments were dangerous due to the underlying mortgage loans—loans encouraged by governmental entities such as Fannie Mae and Freddie Mac and by mandates such as the Community Reinvestment Act.

Instead, what universal banking did was allow the more stable, healthy institutions to absorb other failing ones. Investment banks that found themselves in liquidity crunches, such as Merrill Lynch, were able to be acquired by larger deposit-taking institutions, namely Bank of America, rather than go bankrupt. The ability of these institutions to diversify their activities sheltered the financial system from further losses.

A Solution in Search of Problem

Trading doesn’t make banks riskier, whether proprietary or otherwise. All financial operations, by definition, involve risk. As the Heritage Foundation’s Norbert Michel has written, “Although it seems logical to stop banks from making risky bets with federally insured deposits, banks make risky investments with federally insured deposits every time they make a loan.”

Lending is itself a risk-laden bet with a bank’s own capital and can often be riskier than trading, as we saw during the financial crisis. Further, as securities have many buyers while individual loans often have none, the liquidity risk on commercial loans is often worse than trading.

Most critically, however, is that diversification of activities and revenue streams actually works to reduce risk and make banks more stable. As Mark Calabria, former director of financial regulation studies at the Cato Institute, argues “basic portfolio theory tells us that if you combine two risky activities, they are actually less risky combined then they would be separately…Are we actually making institutions less safe, by forcing what we believe is risky activity out?” This would seem to be the case. It was the most diversified institutions that were the strongest during the crisis, and this remains the case today.

Strangely enough, the Volcker Rule doesn’t even restrict trading based on level of risk, but only on whether or not the trading is proprietary. It is rather seeking to ban a type of activity that they suspect to be risky, based on a financial crisis for which it played no role. This is why Jeb Hensarling, Chairman of the House Committee on Financial Services, described the rule as a “solution in search of a problem”.

A major justification for implementing the Volcker Rule was the belief that risky proprietary trading led, in part, to the financial crisis of 2007-08. Reviewing the history and nature of the crisis clearly shows that this was mistaken. However, the issues with the rule’s enactment don’t stop there. In a separate post I will examine how the Volcker Rule has been implemented, along with its damaging effects upon financial markets, Main Street consumers, and community banks.

This post is the first in a 3-part series on banking regulation and the Volcker Rule.

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