LIKE LEG warmers and mullets, the Volcker rule sounded like a great idea to someone at the time. It couldn’t have found a better namesake than Paul Volcker. In the wake of the 2008 financial crisis, the cigar-chomping former Fed chairman reemerged with his 6-foot, 7-inch frame and gruff voice, sounding as though he might grab a few banks by the neck and start banging heads like Moe Howard in a Three Stooges movie. Instead, he called loudly for a prohibition on proprietary trading by US banks - in-house operations that trade everything from stocks and bonds to gold, oil, and futures.
The Volcker rule, which is meant to keep banks from jeopardizing depositors’ money with risky trades, was written into the Dodd-Frank banking-reform law. Lately, however, the rule has come under heavy fire. Not by angry bankers, but by government regulators and central-bank officials around the world. These aren’t the type of bureaucrats who are afraid of big government. Instead, they’re afraid of unintended consequences - the possibility that the new regulations will limit the markets for government bonds, which today are often purchased by big banks’ in-house trading desks, and will thereby raise borrowing costs around the globe. Maybe they’re wrong. But with final rules scheduled for July, and with the euro hanging in the balance of an “orderly’’ Greek default, we’ve picked a dangerous time to find out.
Though Volcker never wore a mullet, he made the ’80s the ’80s. As Ronald Reagan pushed to cut taxes, reform the code, and scale back regulations, Volcker proceeded to wring inflation out of the economy with tight monetary policy. The 1982 recession was severe, but the subsequent period of low inflation paid economic dividends well into the 1990s. So when the former chairman spoke, people listened. And President Obama pounced, demanding that the Volcker rule be included in the final banking law.
The proposal was always controversial. Opponents argued that with lower leverage and higher capital standards on the way, forcing banks to divest specific business lines was unnecessary. Many supporters saw the rule as the next best thing to reviving Glass-Steagall, the depression-era law separating commercial and investment banking. They failed to notice that Glass-Steagall created stand-alone investment houses like Bear Stearns and Lehman Brothers - some of the biggest forces behind the crisis.
The draft rule was finally released four months ago, unleashing a flood of comments. To no one’s surprise, some came from banks. But many also came from customers who depend on the trading desks for service. America’s largest pension fund, Calpers, signed a letter arguing that the rule would cause “reduced liquidity in the markets, higher trading costs, and reduced valuation of fixed-income securities.’’ These are big problems when you’re investing on behalf of 1.6 million California public workers and retirees.
The pushback from regulators abroad was even more pointed. Japan’s financial services administrator warned that the Volcker rule would raise the costs of trading Japanese government bonds. Britain’s chancellor of the exchequer also sent a letter of objection, while the governor of the Bank of Canada spoke publicly about “obvious concerns.’’ Notably, US bonds get a special exemption, a carve-out that prompted European Union officials to warn of possible retaliation.
These regulators understand that proprietary trading desks aren’t just making money off bond trading; they often play a “market-making’’ role - that is, they help stabilize a potentially volatile market in government bonds. For small countries like Estonia or Costa Rica that issue bonds less frequently, that can be a big deal. The proprietary desks might buy and hold a large block of these countries’ bonds, gradually selling them over time. Of course the banks make money, but governments get access to capital at the lowest possible cost.
Congress knows a good bandwagon when it sees one, so the hearings on the proposed rule have been good theater. Congressman David Scott - a Democrat - somberly observed that, if not implemented correctly, the rule “could have a devastating impact.’’ With five different regulatory agencies writing the rule, don’t hold your breath waiting for clear and effective implementation. In a moment of candor, a Fed governor admitted that “the distinction between prohibited trading and permissible market-making can be difficult to draw,’’ because they look so similar.
None of this means that proprietary trading is without risk, but the Volcker rule’s good intention does not make for good regulation. The most judicious application of a poorly conceived rule can never eliminate the damage from unintended consequences.
Volcker famously quipped that the only worthwhile financial-service “innovation’’ of the past 30 years was the ATM. That invention, like Volcker himself, turned out to be more than just an icon of the ’80s. The Volcker rule, in contrast, might prove about as enduring as the leg warmer - a form of protection that Americans briefly thought they needed, but turned out to be more trouble than it was worth.