The Volcker rule for banks


In the late Nineties, Congress repealed the Glass-Steagall Act (aka the Banking Act of 1933).  Glass-Steagall mandated that commercial banking and investment banking activities could not both be conducted in or by the same legal entity.  The Act was a reaction to abuses that led to the collapse of the stock market in the US during 1929 and beyond.


The bill that repealed Glass-Steagall was the Gramm-Leach-Bliley Act of 1999.  Although formulated by Republicans and passed along party lines in the Senate, the bill received bipartisan support in the House and was signed by Bill Clinton, a Democratic president.  The ostensible purpose of Gramm-Leach-Bliley was to allow American banks to expand activities to compete better with the big foreign “universal” banks, primarily in Europe.  But by once again permitting commercial banks to also do investment banking activities inside one entity, GLB opened the floodgates to the unfettered proprietary trading that has yielded such disastrous results over the past several years.

The ensuing problem

Part of the problem with the American commercial bank/investment bank conglomerates that were spawned by GLB was that the investment bankers and traders working at these entities turned out to be, by and large, either incompetent or dishonest.  In addition they were supervised by commercial bank executives cut from the same cloth, who seem to have had no clue about what the investment bankers they supervised were doing.

In the simplest terms, GLB allowed the investment banks in the combined entities to use the stronger credit rating of the commercial bank parent to lower their borrowing costs.  This financing advantage would in theory lead to “extra” profits in the investment bank and increased financial strength in the parent.

What happened instead was that the investment bankers in these conglomerates “bought” business by accepting lower anticipated returns on the high-risk deals they took part in.  The could do this only because their own cost of funds was so low.  When these marginal deals started to turn sour (it turned out the returns were overestimated in the first place), they ended up not only hurting the investment banks but also destroying the credit ratings of the commercial bank parents.

What is the Volcker rule?

Named after Paul Volcker, the former Federal Reserve chief who broke the back of the accelerating inflation of the late Seventies and ushered in the era of disinflation that followed, the Volcker rule would prohibit any commercial bank from doing proprietary trading, that is, having a desk that buys and sells financial instruments with bank money in order to make trading gains.  A commercial bank could presumably do any other sort of investment banking activity–underwriting new issues of stocks or bonds, managing investment pools for others, investment research, consulting…

Why propose it?  why now?

There’s a tremendous amount of public anger in the US about the financial crisis and its aftermath.  To me, there a number of intertwined issues:

1.  the culture of special interest lobbying in Washington, where legislators seem more interested in receiving lobbyist money than protecting their constituents’ interests.  Anger seems also directed at President Obama, who was elected as an agent of change, but who appears to be tacitly supporting the status quo.  Commentators have also pointed to the huge amounts of money flooding Washington from financial institutions, presumably to forestall regulatory change that would rein in the big banks.

2.  the failure of Congress or federal regulators to prevent–or even identify–problems in the banking system

3.  the apparent eagerness of investigative arms of the government like the SEC to brush financial misdeeds under the rug by closing inquiries with small fines and without prosecuting individuals responsible for them

4.  the immense, and continuing, damage done to the American economy by the banks, with no reason to think the same kind of disaster can’t happen again

5.  the grating fact that the only Americans prospering at present are, ironically, seem to be the very bankers who created the crisis in the first place.

In short, the stage is set for voters to sweep out in the November election the same Democrats swept into office two years ago to replace the Republicans responsible for the fiscal mess Washington created from the turn of the century on.

Hence,the Obama administration’s political need to be seen to be doing something. Voilà–the Volcker rule.

The Volcker Rule has problems the administration may not see

Two of the issues are outlined by Gillian Tett in a recent column in the Financial Times.

1.  Major banks are key market makers through their proprietary trading desks in Treasury securities.  The government has $4 trillion in short-term debt that needs to be refinanced over the next several months.  Will the government be able to refinance itself without a hitch if these important middlemen are reorganized, spun out of banks, shut down–or have their operations disrupted in some other analogous way?  That’s not so clear.

2.  The longer-term issue, which Ms. Tett alludes to, but doesn’t spell out in detail, is the role investment banks play in the conduct of today’s monetary policy.

The textbook model of money creation in the US is that it is done by traditional banks making loans to companies and individuals, under the control of, and in response to signals from, the Federal Reserve.  In reality, money–sometimes immense amounts of it–is also created in securities markets.  For many years, this has occurred through corporate stock and bond issues.  But it also happens through securitization of loans already on banks’ books, which clears the decks for the banks to make new loans.

Securitization, in its turn, requires that the issuing bank retain a small interest in the loans being sold.  To minimize the need to set aside capital as reserves for the retained interest, banks have routinely transferred it to their proprietary trading desks.  If there are no trading desks to hold these interests, the amount of securitization will be smaller than it would otherwise be.

By how much?  A minimum, one would think, would be by the size of the reserves required to be put aside to support the carried interests.  Most likely the number would be higher–how high no one knows.

Given the poor judgment of banks about securitization over the past few years, that might not be a bad thing.  But for any given level of Fed action, money creation will certainly be less than it has been, and economic activity therefore also weaker than history would have led one to expect.

Stay tuned.

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