The administration's proposed "Volcker Rule," which would bar banking organizations from proprietary trading and private fund sponsorship/management activities, is conceptually deficient, will have anticompetitive effects and will not benefit the financial service industry, its customers or the financial economy.
First, the rule would apply to banking organizations that take deposits, the theory being that they enjoy the benefits of the federal safety net and should not be allowed to exploit the cost-of-funding and government backstop benefits that come with that position. In the last crisis, however, the government rescued a number of key non-banking firms and extended the federal safety net to nondepository financial institutions. Thus, barring banks from trading and funds management activities will do nothing to address systemic risks unless the government is prepared to say definitively that any financial institution outside the "no proprietary trading" wall will be allowed to fail.
Second, declaring by legislative fiat that proprietary trading as a risky financial activity will disrupt legitimate and valuable risk-mitigation activities of banking organizations. Much proprietary position-taking and trading by banks is done to hedge the risks associated with customer-related exposures on their banking and trading books. In turn, distinguishing between "speculative" activities on the one hand, and risk-reducing client-driven trading activity on the other hand, is a sophisticated endeavor that is difficult for seasoned regulators, let alone legislators. Moreover, even nonhedging proprietary trading or funds management that is effected for the bank's own account can have useful risk-reduction effects, such as boosting overall financial results and diversifying a banking organization's income sources, which acts as a stabilizing financial influence for banks and the banking system.
Third, the administration's proposal would prohibit depository organizations from "owning" private-equity or hedge funds. Many banking organizations routinely sponsor and manage private investment fund products for their clients without "owning" those funds. They may also make small investments in the fund for tax purposes, or invest in the fund to demonstrate that their financial interests and their clients' interests are aligned. How does separating banks from their traditional customers who want alternative investment products, and reducing the number of providers of these services, protect the banking system or benefit consumers?
Fourth, one of the Volcker Rule's premises is that depository organizations should use their cost-of-funding and safety-net advantages to serve the public by making more credit and other traditional banking services available in the U.S. economy. Suffice to say that the last crisis taught us that banks need to make more responsible loans, not just more loans, and that traditional lending can be highly risky. Artificially depriving banks of the benefits of responsible trading and fund management activities simply puts more pressure on them to generate returns on a narrower business model, which in turn is a recipe for encouraging banks to take lending and other banking risks they might or should otherwise not take. Further, a forced increased focus on lending and the narrowing of permissible revenue sources will make banks more susceptible to fluctuations in, among other things, commercial and real estate markets.
Fifth, unless the administration's proposal is replicated in other major banking markets, the Volcker Rule will put U.S. banking organizations at a competitive disadvantage to their foreign peers and may encourage our global financial firms to move operations overseas to friendlier jurisdictions. Making the proposal applicable to U.S. operations of foreign banking organizations, as the administration proposes, won't seriously mitigate the global anticompetitive impact of the proposal, because foreign banks will simply keep their affected proprietary businesses offshore.
Finally, proponents of the Volcker Rule assert that we need to protect the banking industry from excessive risk-taking and conflicts of interest, and help prevent the "next" financial crisis. But we really don't know what that crisis will be. Legislating against unknowable future events by artificially restricting legitimate financial activities invites anticompetitive behavior and unintended consequences.
