Ex-Fed Chair Paul Volcker has weighed in again with a nice piece for the SEC that defends the rule bearing his name. The Volcker rule, part of Dodd-Frank, bans proprietary trading by investment banks (and others whose primary role is systemically important and not based on trading) — the loose version of the rule is rule is “take the casino out of the bank.” Here is his defense. The difficulty is measuring proprietary trading – it is not trivial to separate gambling from hedging and even (at least banks claim) from trading on behalf of clients.
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The Volcker Rule seems like a baby & bathwater thing. The moral hazard of actually gambling with taxpayer money for private profit is a practice to avoid. But, really, Mr. Volcker is prop trading actually a “casino”? Why can’t we just manage prop trading with better risk controls, e.g., higher capital requirements? Is the VR a tacit admission by regulators that because they don’t know how to manage risk, they’ll just avoid risk?
ummmm. Yes! If the potential downside is that they blow up the entire system, then systemic risk must be minimized/avoided until it can be effectively managed. You don’t jump out of the airplane until you know how to deploy your chute.
Thanks for your response, Jake. But on what basis should we believe that prop trading blew up (and, by extension, would again blow up) the system? Why not point to an insurance conglomerate operating as an unregulated derivative clearing house? Or junk securities carved into tranches, the top level of which received fictitious AAA/Aaa ratings from ratings agencies who were compensated by the issuers? Or Auction Rate Preferreds being sold as cash equivalents? 30:1 leverage ratios? Why not blame The Community Reinvestment Act that drove loans which, though perhaps morally laudable, would never have been made by private capital without top-down pressure?
My point is that the Volcker Rule is knee-jerk regulation, promoted by legislators still obsessed with the demise of Glass-Steagall. The issue is risk management, not elimination. Were it not so, we should prohibit banks from ever making a C&I or consumer loan that fails. What kind of systemic risk is posed by an adequately capitalized bank? That’s Basel III’s prescription, and it seems like a much more reasonable way to regulate the level of systemic risk than does banning a business practice in toto simply because you don’t ‘get it’.
Anyone suggesting that the Community Reinvestment Act had anything to do with the housing bubble and mortgage meltdown is revealing that he knows very little about the events, and is repeating an absurd claim created by the right wing propaganda machine.
Thanks, Dave. I’ve been wrong many times before, why not again now? But maybe you’d be willing to share with the rest of the class precisely how it is impossible to connect social legislation to the lending practices of federally chartered banks and securitizations at the GSEs?
My point was not that the CRA or, for that matter, affordable housing mandates, were the sole causes of the housing crisis, but as Christian deRits at Moody’s Analytics describes “…they may have introduced some distortions and created perverse incentives in the mortgage market…”
The original post was about the Volcker Rule and my responses were oriented toward the thought process behind that rule and whether it’s a suitable remedy. There were many causes that led to the crisis; I cited several of them.
By the way, I’m terribly impressed with how adroitly you were able to pigeon-hole me as knowing “very little” about the bubble and meltdown and that I was simply parroting “right wing propaganda.” You go, girl!
As someone who works as a market maker in a bank, I cannot stress enough how difficult and un-natural proposition is to distinguish facilitation of customer trades from what is referred to as Gambling, When I trade against a client, I gamble with my firm’s money, and this bet is impossible to hedge (while staying profitable).
Moreover, when a buy side investor decides to trade against me – they believe they have good reasons, and on average they are right (this is called Adverse Selection). By taking the other side of the trade, I happen to be, on average, on the wrong side, and the spread is not enough to compensate me for providing that liquidity (otherwise, how would the investor make money??).
So I have to be just a smart as the investor to justify my existence, In other words – in order for me to be able to add liquidity when there is shortage – I have to be able to take some risk when liquidity is abundant, as if I was the buy side investor myself. And this makes this VR unrealistic.
The other metrics mentioned in the letter (variance of returns, size of book, etc..) are simply irrelevant.
The right solution, as pointed out earlier, is more transparancy around risk and controls, rather than an outright ban.