If timing is everything, this is not an auspicious time to argue against the Volcker Rule, given the recent London trading and investment misadventures of JPMorgan Chase. Predictably, there has been a hue and cry over this situation, and the bank regulators will be under heavy political pressure to toughen the Volcker Rule. In turn, the regulatory agencies probably will stiffen the Volcker Rule’s implementing regulations when they are adopted later this year (perhaps). For that reason, now is a good time to take a critical look at the Volcker Rule’s utility in improving regulatory oversight and preventing future financial crises.
In fact, the Volcker Rule continues to exist in a parallel universe that has little relation either to the recent financial crisis, the functional realities of the modern financial markets, or to the ongoing efforts to strengthen our financial system. Nothing that JPMorgan Chase, or any other too-big-to-fail bank, has or has not done changes that essential fact. Here is why:
1. Proprietary trading did not cause the financial crisis. No matter what the proponents of the Volcker Rule argue, they cannot mount a persuasive case, with credible evidence, that banks’ proprietary trading and hedge fund investing were material contributors to the 2008 financial meltdown. The only comprehensive government study of the financial crisis, the report of the Financial Crisis Inquiry Commission, doesn’t support this claim. The ultimate causes of the financial crisis included a combination of excessive origination, purchases and leveraging of low-quality mortgage assets; the impact of the OTC derivatives and securitization markets in accelerating the transmission of financial distress when the mortgage markets began to fail; inadequate regulatory oversight of the participants in the home mortgage and structured finance markets; and a general failure on the part of the financial markets and their regulators to recognize and address the correlation risks associated with the dramatic growth in this asset class. These phenomena provide a much better explanation of the causes of the crisis than does proprietary trading and hedge fund investing. So, it follows that. . . .
2. Had the Volcker Rule been in existence, it would not have prevented the last crisis. There are numerous reason why this is the case, but to summarize just a few: (i) the acute financial crisis was precipitated largely by the failure of nonbank financial institutions, including Fannie Mae, Freddie Mac, AIG (which functionally was a nonbank firm) and of course Lehman, to which the Volcker Rule would not have applied; (ii) the large banks that did fail or came close to failure (IndyMac, WaMu, Wachovia) did so due to liquidity crises prompted by market concerns over their ability to meet their short-term obligations, which in turn was a function over broader concerns over the size and quality of their mortgage asset portfolios, and not their proprietary trading or hedge fund investing; and (iii) a large number of hedge funds that were major participants in the trading of derivatives, structured securities and other opaque, high risk instruments were not affiliated with banks and therefore also would have been beyond the reach of the Volcker Rule.
3. The Volcker Rule will not prohibit the purchase of bad assets. The Volcker Rule prohibits trading in securities, derivatives and commodity derivatives. It does not prohibit the simple purchase of these instruments, let alone the accumulation of bad commercial or consumer loan assets that have been the principal cause of most bank failures. So, if a bank wants to load up its portfolio with complex mortgage-backed securities, other quirky structured instruments and opaque derivatives, it is free to do so under the Volcker Rule — all the bank has to do is not trade those instruments. Although the full particulars of JPM Chase’s London losses are not publicly known, current indications are that many, if not most, of the transactions that led to the reported losses consisted of position-taking, not position trading.
4. Banks are in the business of taking risks. Commercial banking (and investment banking) is about taking risks. There is a risk in effecting a proprietary trade or sponsoring a new private fund, just as there is in making a commercial loan, in buying a security (even a Treasury security), in deciding what interest rate to pay on a deposit, and so forth. Without the assumption of risk, there is no banking business and therefore no financial intermediation system. Are there activities that are too risky for banks to undertake? Perhaps so, but the evidence doesn’t support the proposition that all trading and private fund sponsorship/investment activities are so inherently risky that they need to be banned. One could make a more plausible case, based on the recent crisis, that subprime and commercial real estate lending activities are too risky for banks to undertake.
5. Banks have to be allowed to hedge their risks. Contrary to the claims of some that the industry persuaded the regulators to “weaken” the Volcker Rule’s basic proprietary trading ban by getting the regulators to allow portfolio hedging in their proposed regulations, portfolio-level (or “macro”) hedging has been a mainstay of prudent bank asset-liability management activities for a long time. And, portfolio hedging should continue to be allowed. For example, if a banking organization believes that adverse economic developments in the corporate debt markets are threatening its commercial loan portfolio, why would we want to tell the banking organization that it cannot hedge the growing risk in the portfolio?
6. You usually don’t know proprietary trading when you see it. The proprietary trading/hedging debate is shorthand for describing the long-standing regulatory challenges in distinguishing between speculation and risk-mitigation in the banking book of a financial institution. Veteran regulators will tell you that there is no bright line between speculative trading and risk-mitigating trading. While there are activities on one end of the spectrum that could easily be identified as blatant speculative trading, and activities on the opposite end that are just as plainly risk-reducing in nature, most financial instrument trading falls in the broad and highly granular continuum between those two extremes. What is worse for regulatory implementation purposes, the market environment in which financial instrument trading takes place is highly complex and dynamic. Thus, a trade that is speculative on a Monday may become risk-mitigating by the following Friday, and vice-versa; in fact, precisely this dynamic appears to have contributed to JPM Chase’s London losses. Under the circumstances, the attempt to draw quantitative — and artificial — regulatory distinctions between “good” and “bad’ trading activities will be highly cumbersome, expensive to implement, and probably ineffective in an unacceptably large number of cases.
7. The Volcker Rule doesn’t accomplish its primary goals. One claim that is often used to support the need for the Volcker Rule — that taxpayer funds shouldn’t subsidize banks’ risky proprietary activities — doesn’t make sense if a primary purpose of the Dodd-Frank Act is to end “too big to fail.” If the Dodd-Frank Act has ended TBTF, it is shareholder and creditor, and not taxpayer, funds that are at risk when a banking organization decides to speculate with its balance sheet.
The other principal claim use to support the Volcker Rule is that the Federal financial safety net (including borrowing from the Federal Reserve, payment systems access, deposit insurance) should not support proprietary risk-taking. There are at least two things that are wrong with this assertion. First, it assumes that unwanted proprietary activities can be accurately identified in the first place, and that is an optimistic exercise at best (see point 6 above). Second, singling out trading and private fund sponsorship or investment activities as “bad” proprietary activities for this purpose makes little sense. For example, banks have long been in the business of investing in debt securities, and banking organizations more recently have been making merchant banking and other equity investments, and those activities are just as “proprietary” as trading activities. In addition, it is difficult to see how private fund activities, which in most instances are conducted to accommodate a banking organization’s corporate finance, wealth management and asset management clients, logically can branded as “proprietary.”
8. The need for controls over trading and fund investments is not a Volcker Rule issue. Whatever the outcome of the JPM Chase situation, all indications are that the principal “lesson learned” will be nothing more — and nothing less — than a reminder that risk management controls over trading, investment and other risk-taking activities (including lending!) need to be appropriately robust in their development, implementation and enforcement. Federal Reserve Board Chairman Ben Bernanke and Governor Dan Tarullo said as much when they told Congressional panels that had the Volcker Rule been in place, the regulators would have had more information at an earlier point in time about JPM Chase’s London activities, and the bank would have had to engage in more proactive risk management of these activities. But the point here is that the Volcker Rule is not needed to accomplish these objectives. The bank regulators already have all the authority they need to ask banks for information on any bank investment, trading and risk-mitigation activities, and access to this information is an integral and normal part of risk-based supervision. And, if the regulators believe that banks need to improve their risk management activities for their investment and trading activities, they don’t need the Volcker Rule to make this happen.
9. The Volcker Rule debate is a diversion from a broader discussion about the structure of the U.S. banking system. One collateral consequence of the latest Volcker Rule debate are calls for broader structural regulation of the U.S. financial markets, such as the reimposition of the Glass-Steagall Act barriers between commercial and investment banking activities. Putting aside the substantive merits of these proposals, if there is a belief that there is too much proprietary risk in the banking system, or that banks need to tend more to the business of serving customers rather than themselves, that is a legitimate debate to have. But the Volcker Rule is a poor vehicle for that discussion. To the contrary, it is an artificial, unnecessary, diversionary and unproductive distraction in the debate over the most effective way to supervise and mitigate systemic and institution-specific financial risk.
The industry and the regulators have spent far too much of their limited time and resources in trying to understand and apply the inherent and fundamental illogic and flaws in the Volcker Rule. In a better world, the financial services regulators would put the Volcker Rule aside altogether and pay more attention to meaningful regulatory reform matters through a focus on strong governance, effective risk management, sufficient regulatory capital, and proactive and holistic supervision. Since Congress has precluded this result, however, the most productive course of action for the regulatory agencies is to scrap the current Volcker Rule implementation proposal, propose an alternative regulatory framework based on broad and clear principles, effective risk management controls and oversight, and active supervision, and make the best of what is currently an almost-impossible implementation task.