Unintended Consequences Worries Delay Volcker Rule Implementation

Published June 11, 2012

Financial institutions that do “proprietary trading” are coming under fire for high-profile losses that critics say could put taxpayers at risk.

Meanwhile, some analysts say measures aimed at restricting or eliminating the practice could make the financial system even riskier.

The latest major proprietary trading loss involved more than $2 billion lost by JP Morgan Chase, announced in May by CEO Jamie Dimon. Dimon’s political reach, however, may make things difficult for those who want a crackdown on the practice.

Among other things, Dimon sits on the board of the Federal Reserve Bank of New York, which regulates Dimon’s bank. He is also an adviser to President Barack Obama, whose administration has been calling for curbs on proprietary trading.

Volcker Rule Delay

Proprietary trading started garnering headlines in the aftermath of the 2008 credit crisis. In proprietary trading, a financial firm trades financial instruments such as stocks, commodities, or derivatives with its own money, not its customers’, to make a profit for itself. This is different from regular trading, where the bank’s profits come from commissions for processing trades.

Former Federal Reserve Chairman Paul Volcker and other advocates of increased government intervention argue speculation at proprietary trading desks of many banks played a key role in the financial crisis of 2008. Volcker recommends new restrictions forbidding U.S. banks from making certain kinds of speculative investments that do not benefit their customers.

These provisions, known collectively as the Volcker Rule, were made law in the Dodd-Frank Financial Reform Act and were scheduled to take effect July 21, 2012. But concerns raised by Volcker Rule critics have convinced the Federal Reserve to delay its implementation. The Fed is giving banks until July 2014 to come into full compliance with the Rule, though the banks will be required to show they are preparing for full compliance..

Trading, Lending Separation

The Volcker Rule forces separation of the investment banking, private equity, and proprietary trading sections of commercial financial institutions from their traditional consumer lending divisions.

In a letter to Federal Reserve Chairman Ben Bernanke and other regulators, Senators Carl Levin (D-MI) and Jeff Merkley (D-OR) argued the Volcker Rule will affect relatively few banks and help the financial system grow. They helped write the provisions that put the Volcker Rule into the Dodd-Frank Act.

“While the vast majority of banks will be unaffected by the provisions, the prohibition on proprietary trading will unquestionably reduce some banks’ trading. Proprietary trading, regardless of where it occurs within a bank, is prohibited. These provisions are squarely aimed at the handful of very large banks that, with the implicit subsidy of taxpayers, dramatically expanded their hedge fund-like trading operations in the run up to the crisis, and subsequently relied on taxpayers to bail them out,” they wrote.

“U.S. capital markets will be the stronger under the Volcker Rule,” they added. “With fewer conflicts of interest and more reliable market-makers, our markets will be healthy and vibrant, just as they were when the Glass-Steagall Act protected our financial system.”

The Rule also prohibits financial institutions, or companies that own a bank, from engaging in proprietary trading that is not done specifically at the request of its clients. Commercial banks would also be disallowed from owing or investing in a hedge fund or private equity fund. The Rule would also limit the amount of liabilities the largest banks and financial firms could hold.

Enforcement, Competitiveness Concerns

Critics of the Volcker Rule argue it will be difficult to enforce, have little effect on systemic risk, and could cut banks’ competitiveness.

David C. John of the Heritage Foundation argues the Volcker Rule might increase financial risks rather than reduce them.

“If fully implemented, the Volcker Rule is similarly likely to backfire and to end up making the financial system riskier than it would have been without it. As with Glass–Steagall, the Volcker Rule’s poorly designed attempts to restrict bank activities is likely over time to keep banks from meeting legitimate customer needs, forcing those customers to move their business to other providers,” wrote John in an April 26 Heritage Issue Brief.

John Berlau, director of the Center for Investors and Entrepreneurs at the Competitive Enterprise Institute, argues the Volcker Rule is based on the false premise that trading is more risky than writing loans.

‘Not Inherently More Risky’

“There is nothing inherently more risky about trading—short-term or long-term—than making loans,” Berlau says. “Supporters of the Volcker Rule say banks shouldn’t be ‘gambling’ with taxpayer money, and indeed deposit insurance should be reformed and gradually phased out so that all institutions as well as savers and investors are more risk-conscious.”

Berlau also says that by restricting a bank’s ability to invest, the Volcker Rule actually increases risk.

In a Newsmax column, he wrote, “But policymakers must recognize that every time a financial institution engages in an economic transaction—whether a loan or a trade—it is making a ‘gamble’ that it will never get its money back. Limiting a bank’s ability to take equity in a firm by saying it can lend but not invest to that particular firm will result in less, not more, protection from risk.”

Internet Info

“Volcker Rule May Make the Banking and Financial System Riskier,” David C. John, Heritage Foundation: http://heartland.org/policy-documents/volcker-rule-may-make-banking-and-financial-system-riskier