On Tuesday, the Financial Stability Oversight Council may issue its recommendations for implementing the Volcker Rule, the provision of the Dodd-Frank financial legislation that bans so-called proprietary trading by banks.
Initial reports indicate that the council may try to assuage some concerns about the rule’s economic effects by attempting to draw a line between long-term investing from short-term trading. Congress, however, should still repeal this senseless rule that is already showing signs of doing lasting damage to the economy and which will most likely add, not lessen, systemic risk.
The Volcker rule is based on the faulty premise that a financial institution making a loan — any loan — is somehow inherently more dangerous than investing or trading. It was that premise that led to the enactment of Glass-Steagall in the Depression that separated “commercial” from investment banking.
After evidence of the damage that Glass-Steagall was doing to U.S. competitiveness plus empirical studies that showed it did not protect the financial system from systemic risk, the Clinton administration and a large bipartisan majority in Congress largely repealed it in 1999.
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Yet bad ideas have a way of coming back to life, and Glass-Steagall’s repeal was falsely blamed for the financial crisis — a crisis primarily causes by lax lending standards on traditional mortgage loans — loans bought by the quasi-government entities Fannie Mae and Freddie Mac and encouraged by laws such as the Community Reinvestment Act.
As Peter Wallison, fellow at the American Enterprise Institute and a commissioner on the congressionally-created Financial Crisis Inquiry Commission, has written, the commercial banks that imploded all went bust “by investing in bad mortgages or mortgage-backed securities, not because of the securities activities of an affiliated securities firm.” (Wallison and some of his fellow commissioners are expected to detail the amount of bad loans influenced by government rules in their final FCIC report, which may be written as a dissent.)
The Volcker rule restricts banks, and in some cases insurance holding companies, from ”proprietary trading” — which it defines as trading for the institution itself rather than for its customers. But this is based on a similarly false premise.
There is nothing inherently more risky about trading — short-term or long-term — than making loans. 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.
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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.
And already, the Volcker rule may be hindering economic recovery. John Maggs reports in Politico that banks are losing top traders to hedge funds, because of uncertainty about the rule. Banks ability ”make markets” for investors by buying a particular security may be sharply restricted, which in turn could slow down the formation of new businesses that create new jobs.
And even though this supposedly was taken care of by giving regulators more flexibility, there is still concern that the rule will affect many insurance companies investments in blue-chip stocks. These are investments that are encouraged and even required by state insurance commissioners as a way for companies to diversify their investments for solvency.
Hopefully, the recommendations of the council will blunt some of the rules worst economic effects. But due to unnecessary restriction and uncertainty that will still linger, Congress should repeal the misguided Volcker rule and move on to the Dodd-Frank “financial reforms” glaring omission — the behemoths Fannie Mae and Freddie Mac, which were at the center of the crisis.