Volcker Rule Curbs Useful, Profitable Proprietary Trading, Not Risky Lending

by Hans Bader on December 11, 2013

in Bailout Watch, Economy, Regulation

The government just approved a regulation called the Volcker Rule to curb proprietary trading by banks — even though such trading did not cause the financial crisis, or lead to massive financial losses by banks and taxpayers the way other, much riskier practices by banks did (like risky mortgage loans, which the Obama administration has pressured banks to once again engage in, in the name of fair lending and affordable housing).

The Wall Street Journal reports:

All five regulatory agencies put to a vote and approved the Volcker rule on Tuesday, ushering in a new era of tough oversight that drills to the core of Wall Street’s profitable markets and trading businesses.

The rule will put in place new hurdles for banks that buy and sell securities on behalf of clients, known as market making . . . The Federal Reserve also approved an extension to give banks until July 2015 to comply with the rule.

(The above report is from the Journal’s liberal-leaning news staff, not its conservative editorial page, which has questioned the Volcker Rule.)

At Bloomberg News, financial columnist Matt Levine opposes the Volcker Rule, although he says that banks may manage to partly evade its harmful restrictions:

the Volcker rule — which will prohibit U.S. banks from engaging in “proprietary trading” but with exemptions for “market-making” and “hedging” — is dumb for all the obvious reasons. It is impossible to conceptually distinguish “prop trading” from “market-making,” so the Volcker rule will make market making more difficult and expensive and reduce market liquidity. It is impossible to conceptually distinguish “prop trading” from “hedging,” so the Volcker rule will make banks less hedged and more risky.

But the biggest conceptual objection to the Volcker rule is that its central premise makes no sense. Proprietary trading had basically nothing to do with the financial crisis, and banking is about taking “proprietary” risk with depositor money. This is mostly called “lending,” but calling it “lending” doesn’t make it safer than calling it “prop trading.” The reverse is mostly true; here’s a [discussion by investment analysts]: “But the notion prop trading is inherently riskier or subject to greater realized losses than plain old lending, as we saw in 2008, is flawed. Loan losses didn’t just dwarf trading losses in absolute terms. Loan losses as a share of banks’ total loan portfolios also exceeded trading losses as a share of banks’ trading accounts. Yet no one’s arguing banks should stop lending in order to protect depositors (and rightly so). In short, those expecting the Volcker Rule to be a fix-all for Wall Street’s ills have probably misplaced their hope — the rule seems like a solution desperately seeking a problem.”

As he notes, the Volcker rule may be evaded by banks partly by making their practices less transparent:

Things that are cast as “proprietary trading” can easily be recast as “lending.” Mortgages can come in mortgage-backed-security flavor on your trading book, or in whole-loan flavor on your lending book. You can give hedge funds leverage by writing them swaps (prop trading! . .) or by lending them money (lending!). Actually you don’t even have to recast trades as loans to avoid the Volcker rule: Just recast them as trades that you intend to hold for at least 60 days and you should be good. . . “Morgan Stanley and Goldman Sachs will go out and hire the best and brightest lawyers, and they will say, ‘How do we do this?’”  said Bill Singer, a securities lawyer who . .  advises clients on regulatory compliance. “The mind-set,” he said, is “how do we get around it?” . . .the Volcker rule has some tendency to make the risks of banking less transparent.

In restricting useful proprietary trading — rather than doing something about the risky lending (promoted by politicians) that helped spawn the financial crisis – the federal government is behaving like the drunk in the allegory about lost car keys, who did something useless, just so he could act like he was doing something:

A police officer sees a drunken man intently searching the ground near a lamppost and asks him the goal of his quest. The inebriate replies that he is looking for his car keys, and the officer helps for a few minutes without success then he asks whether the man is certain that he dropped the keys near the lamppost.

“No,” is the reply, “I lost the keys somewhere across the street.” “Why look here?” asks the surprised and irritated officer. “The light is much better here,” the intoxicated man responds with aplomb.

Rather than curbing profitable trading, it would have made more sense for the federal government to rethink costly regulations that pressure banks to make risky mortgage loans, especially to certain favored borrowers. But that would have required more political courage on the part of federal officials, and maybe even an ability to admit their own culpability in the 2008 financial crisis.

The financial crisis was caused partly by “diversity” mandates and affordable housing mandates that encouraged lending to people with bad credit scores who later defaulted on their loans. Banks were under great pressure from liberal lawmakers to make loans to low-income and minority borrowers. For example, “a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers,” The New York Times noted. As a result, taxpayers ended up having to spend countless billions bailing out government-sponsored mortgage giants like Fannie Mae that bought up risky mortgage loans.

But nothing has been done to remedy those government abuses, which the Obama administration would like to exacerbate.

Comments on this entry are closed.

Previous post:

Next post: