The Volcker Rule
What’s at stake: Obama’s sweeping proposal for financial regulation took the world by surprise. The new White House initiative on limiting bank size and restricting the activities of depository institutions, , including speculative proprietary trading and investing in private equity and hedge funds, drew some words of support but no commitment to follow suit from […]
What’s at stake: Obama’s sweeping proposal for financial regulation took the world by surprise. The new White House initiative on limiting bank size and restricting the activities of depository institutions, , including speculative proprietary trading and investing in private equity and hedge funds, drew some words of support but no commitment to follow suit from Britain, France or Germany. Though not a full return to Glass-Steagall, the law that separated commercial banking and investment banking in the wake of the Great Depression (and was repealed in 1999), it is at least a return to its spirit and marks a significant change in the administration thinking which had until now seemed content to shackle the banks with tougher regulation, including higher capital ratios, rather than breaking them up or limiting what they could do.
The Economist has a concise analysis of what is in the plan. The first half of the plan concerns restrictions on the scope of activities. Banks that have insured deposits, and thus access to emergency funds from the central bank, would not be allowed to own or invest in private equity or hedge funds. Nor would they be able to engage in “proprietary” trading – punting their own capital – though they could continue to offer investment banking for clients, such as underwriting securities, making markets and advising on mergers. The second part focuses on size. Banks already face a 10% cap on national market share of deposits. This would be updated to include other liabilities, namely wholesale funding. The aim is to limit concentration, which has increased greatly over the past 20 years, accelerating during the crisis as healthy banks bought sick ones. The four largest banks now hold more than half of the industry’s assets.
Simon Johnson writes that at the broadest level, Thursday’s announcement from the White House was encouraging – for the first time, the president endorsed potential new constraints on the scale and scope of our largest banks, and said he was ready for “a fight”. Increasingly, however, there are very real indications that the conversion is either superficial (on the economic side of the White House) or entirely a marketing ploy (on the political side). Secretary Geithner’s spin on the Volcker Rule, Thursday night, is in direct contradiction to what the president said. At first, it seemed that Geithner was just off-message. Now it is more likely that he is (still) the message. Second, the administration’s proposal to freeze biggest bank size “as is” makes no sense at all. Twenty years of reckless expansion, a massive crisis, and the most generous bailout in human history are not a recipe for “right” sized banks.
Viral Acharya and Matthew Richardson, both from NYU’s Stern School of Business, write that it is scope rather than scale that matters most. There is little rationale for hard restrictions on size as it is clear that for diversification purposes as well as efficient market-making or liquidity provision, firms need to be large. It is the complexity of large financial institutions that seems a primary issue in resolving them efficiently, which can be effectively addressed through scope restrictions. On the other hand, separating commercial banking and other forms of financial intermediation from proprietary trading, equity investments and holding of structured investment products is a step in the right direction as it limits systemic risk without affecting financial sector’s ability to perform its core functions.
Paul Krugman does not think that too-big-to-fail is at the heart of our financial problems. Nor does he think a sharp separation between narrow banking depository institutions and other financial players is a silver bullet: unless the shadow banking system is really reined in, financial institutions will create things that look like deposits, act like deposits, but don’t have an FDIC guarantee; yet in crisis, there will be strong incentives to bail them out anyway. Paul Tucker, the Bank of England’s deputy governor for financial stability, made a similar point in a speech noting that banking-style risks emerged all over the financial system in recent years, with little or no relationship to whether the entity was a deposit taking institution or not.
Justin Fox says that the biggest troubles at the big banks and investment banks had to do activities that were related to serving customers. Hedge funds, private equity funds and proprietary trading operations at large banks and investment banks had little to do with the financial crisis we just went through. Yes, there were those two Bear Stearns subprime-mortgage hedge funds that imploded in the spring of 2007. But they would have had about the same impact if they weren’t linked to Bear. The biggest troubles at the big banks and investment banks had to do activities that were related to serving customers. All those toxic CDOs that weighed down Citi and Merrill and UBS were intended to be sold. It’s just that customers stopped buying at some point in 2007.
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