Regulators, politicians, bankers, and former Federal Reserve Chairman Paul Volcker himself are all searching for a simple, easy to understand, yet effective way to implement the Volcker Rule that is consistent with a safe and sound banking system. We agree and believe we have a solution that should be of interest to all concerned.
The Volcker Rule, which is part of the Dodd-Frank financial reform law, is intended to impose strict limits on banks engaging in "proprietary trading" – i.e., betting the bank's capital by significant speculative trading in financial instruments. Congress, as usual, gave general direction to the regulators to figure out how to implement the concept.
The regulators' proposed rulemaking on the Volcker Rule is a whopping 298 pages of complexity that is not only difficult to understand but nearly impossible to monitor and regulate. There is a better way.
We should note there is no evidence that proprietary trading caused or even contributed to the recent financial crisis. But like many financial products, especially loans, proprietary trading indeed has risk. This risk should be carefully and intelligently monitored and regulated.
The question regulators are trying to answer is this: Is the risk of holding an inventory of securities to enable customers to readily buy or sell securities through a bank reasonable, or is it so excessive that changes in the market price of that inventory could put the institution in serious jeopardy?
It's perfectly legitimate and logical that a financial institution, like any seller of products in any industry, would hold more of a product in inventory if it thinks the price of that product might go up in the near future, and hold less of it if the bank thinks the price might go down. We would not call this proprietary trading but rather common sense. Farmers and energy companies do it, as do manufacturers.
It's foolhardy to try to read the minds of traders at financial institutions to determine if the inventory they are keeping is larger than the expected demand. The solution to the problem is straightforward – simply limit the amount of "trading" revenue as a percentage of the firm's total revenue to a minimal level (say 10%).
Monitor the trading results over time, and lower the cap for any bank that consistently loses money on trading positions until the bank adjusts its processes and risk taking and is no longer losing money in the activity. Trading revenues in excess of the 10% limit would be suspect, and the bank would be required to demonstrate conclusively to the regulators they were not the result of proprietary trading and were in fact due to customer-related transactions. If the bank could not meet its burden of proof it would be required to reduce its inventory and the accompanying risk.
Financial institutions cannot earn more than their cost of capital without taking risks. Moreover, they are of no value to their customers or the economy unless they take prudent risks. The key to risk taking is to diversify so that no component of risk taking accounts for an outsized share of a firm's revenue.
Limiting investment in securities used primarily for customer transactions to 10% of the firm's revenue, carefully monitored by regulators, is a simple and easy to understand way to put the Volcker Rule into practice. It would allow financial institutions to serve their customers in a safe and sound manner without placing the firms at risk of failing.
Richard M. Kovacevich is the retired chairman and CEO of Wells Fargo & Co. William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is senior managing director and global head of financial institutions at FTI Consulting, chairman of Fifth Third Bancorp and author of Senseless Panic: How Washington Failed America. The views expressed are their own.