In all the excitement, a lot of commentators have been writing posts arguing that the Volcker Rule is either unnecessary or perhaps even counterproductive. Both Matt Levine and Tyler Cowen have summed up these cases well.
There are usually six different complaints about the Volcker Rule. By addressing them, we can lay out the case for why this rule is important and worth strengthening. I’ll take the complaints in order from least to most important:
1) “The Volcker rule isn’t a fix-all for Wall Street’s ills, and it might not even be a necessary component of reform. Why are we bothering to do this complicated thing?”
Let's back up: The Dodd-Frank Act included a series of reforms that were designed to reinforce each other. The ultimate goal is to build a financial system that helps the real economy while also both preventing future crises and having the correct tools to deal with crises when they do happen.
In order to limit the government’s need to act as a safety net during a crisis, regulators are creating various tools that try to do three big things: First, the financial sector will have to internalize some of the costs of crises and insurance. Second, there’s more supervision of banks through things like capital requirements. Third, there are limits on the sorts of activities the banks can do.
The Volcker Rule mainly focuses on the third component — it prevents banks from engaging in “proprietary trading,” which essentially removes the parts of banks that gamble and act like hedge funds, because those parts can blow up quickly (see here for more).
It’s also a conceptual and cultural shift: Banks need to be boring again and focus on their core business lines. As Marcus Stanley of Americans for Financial Reform wrote, the Volcker Rule creates “a new definition of the dealer or market maker role that is more stable and reliable due to the removal of proprietary trading incentives.” This role will still support lending and credit but will also create a new “reliable utility role for dealer banks in the financial markets.”
That’s all just to say that there’s no one single “fix-all” reform here. All three components of financial regulation need to hang together. That involves a well-capitalized banking sector with high leverage, liquidity, and risk-adjusted capital. It also involves a sane over-the-counter derivatives market. And it requires a credible mechanism to force losses on to investors at firms that were previously "Too Big To Fail." Those components have to work together.
2) “That’s fine, but seriously, this rule would have done nothing useful in solving the last financial crisis. It’s a solution in search of a problem.”
Perhaps. But “solving the last financial crisis” is only one of many goals here. There are other problems that the Volcker Rule does address, at least in part:
First, take resolution authority—the legal regime that’s designed to wind down very large banks and institutions that run into trouble. By preventing banks from engaging in proprietary trading, the Volcker Rule actually makes this task easier. Proprietary trading is notorious for creating quick, large losses, which makes it harder for regulators to deal with failing institutions (resolution authority typically involves nudging banks to better capital while giving regulators the tools necessary to take over failing firms—see more here).
The Volcker Rule also works in concert with other reforms, providing a backstop if those rules don’t work out. If derivatives regulations turn out to be insufficient, for instance, then the Volcker Rule still prevents large banks from carrying out huge bets on tail risk through the derivatives market.
The Volcker Rule would have also helped make the last financial crisis less extreme. “Certainly proprietary positioning played a role in the crisis,” says Caitlin Kline, a former derivatives trader who now works at the non-profit Better Markets. “Banks amassed inventories of high-yielding highly-rated products with largely overnight funding, and this street-wide carry trade helped cause a massive liquidity crisis and then solvency issues, which was a major factor. The Volcker rule will absolutely affect most front-office desk's ability to warehouse huge positions like that.”
3) “Sure proprietary trading might be dangerous, but so is lending money. In fact, lending money is even more dangerous, given the losses in the crisis, so why don’t you ban banks from doing that too!”
The problem there is that lending to households and businesses is the core function of banking. And there are good reasons why banks provide this service instead of other types of firms. For instance, funding increases as relationships between firms and creditors evolve (for more, see Fama 1985 or Petersen and Rajan 1994).
So other firms can’t easily do what banks do when it comes to lending. But other firms can definitely engage in proprietary trading—including hedge funds, mutual funds, sovereign wealth funds and others. So if proprietary trading does have any benefits to society at large, there’s nothing to worry about. It will still take place. On the other hand, if banks are prohibited from lending, it’s not clear that other institutions could pick up the slack.
4) “Allowing banks to have more business lines allows them to diversify their income streams, which will, all things being equal, make the financial system more stable."
Neither theory nor evidence backs up this complaint. Financial theory tells us that we should distinguish between risks to individual firms and risks to the broader market. An economic crisis is the result of market-wide risks, and there’s good reason to believe that market-wide risk will go up as banks increase their business lines. That’s why the Volcker Rule is useful.
Diversification may reduce risks at each institutions, but it leads to the sharing of risks across institutions — different firms all become exposed to similar types of risks. That’s a problem, since it’s harder for regulators to tackle a variety of firms that all start failing at once. (For more, see Wagner 2006, De Jonghe 2009).
As Alexis Goldstein notes, “all the gains made by stand-alone prop trading desks from 2006–10 were entirely wiped out by prop trading losses” during the financial crisis. If diversification was a good thing, we would have seen these profits soar during the crisis. Instead, the desks all lost money at the same time, further exacerbating the crisis.
5) “The Volcker Rule will decrease liquidity and available financial services, making the financial sector more vulnerable and less able to meet the needs of the real economy.”
This is a concern, but the status quo wasn’t ideal on this front, either. During the last financial crisis, liquidity in the markets disappeared, which shows how vulnerable we are if liquidity is concentrated in a few large banks who have access to the safety net (see Richardson).
The Volcker Rule is designed to allow banks to continue core functions like “market-making” — that is, matching buyers with sellers or acting as an intermediary by using financial instruments. Even so, some liquidity will move to other firms that don’t depend on the banking safety net, creating more competition. This is a perfectly appropriate response.
6) “It is impossible to distinguish between prop trading and the legitimate functions that firms are supposed to be able to still engage in, like market-making and hedging.”
This is the correct debate to be having. There are certainly some activities that are clearly considered “proprietary trading,” and banks will be barred from doing these. But there are real questions and gray areas surrounding activities that want to keep banks doing, such as market-making or hedging against risks. As discussed here, we’ll want to keep a close eye on how banks change after the rule is implemented. But the regulators see this as their job and are moving on the task.
So, rebuilding the core banking sector to be boring and focused on their core business lines, while mitigating systemic risks and enforcing other parts of reform. What’s not to like?
Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on Twitter here.