During the presidential campaign, then-candidate Donald Trump called for a 21st-century Glass-Steagall Act. While that Depression-era law required the complete separation of commercial and investment banking, it is unclear exactly what now-President Trumps envisions in a modern version. His Treasury secretary nominee reiterated support for such a framework, yet signaled that the administration opposes a sharp line between banks and investment banks.
The answer of what a modern-day Glass-Steagall looks like may lie with another, crisis-era reform: the Volcker Rule.
The Volcker Rule refers to the part of the Dodd–Frank Act originally proposed by former Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments for their own accounts. More important, the Volcker Rule addresses the conflict of interest that arises when a bank acts on behalf of a customer, on the one hand, and trades for its own account, on the other. The rule prohibits any activity that would “result in a material conflict of interest between the banking organization and its clients, customers, or counterparties.”
Think of the Volcker Rule as a halfway step back to the explicit and complete division between commercial and investment banking under Glass-Steagall. Banks are prohibited from trading for their own account, either directly or via internal funds, but without a division of the legal entities. This means that all of the capital of banks under the Volcker Rule is essentially sequestered from trading, which causes a diminution of liquidity in the financial markets.
The Financial Choice Act sponsored by House Financial Services Committee Chairman Jeb Hensarling, R-Texas, would repeal the Volcker Rule, but this would be a mistake. That said the rule is in serious need of reform to prevent it from going too far and sapping market liquidity. Judging from Treasury Secretary-designate Steven Mnuchin’s recent remarks to the Senate Finance Committee, this line of thinking may be where the administration is headed. Although he sounded alarm over how the rule is affecting market liquidity, he noted, “The concept of proprietary trading does not belong with banks.”
A September 2016 paper by Maureen O’Hara of Cornell and Xing (Alex) Zhou of the Federal Reserve Board stated that “the illiquidity of stressed bonds has increased after the Volcker Rule.”
“Dealers regulated by the Rule have decreased their market-making activities while non-Volcker-affected dealers have stepped in to provide some additional liquidity,” they said in the paper. “Furthermore, even Volcker-affected dealers that are not constrained by Basel III and … [stress test] regulations change their behavior, inconsistent with the effects being driven by these other regulations. Since Volcker-affected dealers have been the main liquidity providers, the net effect is that bonds are less liquid during times of stress due to the Volcker Rule.”
At the time that the Volcker Rule was implemented, I opposed it because of the obvious constraints that the rule imposed on market liquidity. Those constraints have played out since the rule was finalized. But it bears mentioning that the Volcker Rule addresses one of the key problems on Wall Street, namely the tendency of universal banks that engage in both lending and dealing in securities to self-deal.
Repealing the Volcker Rule is consistent with the administration’s interest in a modern Glass-Steagall-like structure. The House committee’s summary of the Choice Act states that “the Volcker Rule has been a solution in search of a problem” and that “it seeks to address activities that had nothing to do with the financial crisis.” But this is fundamentally wrong.
In addition to limiting obvious conflicts of interest among firms that both lend and deal in securities, the Volcker Rule also prevents larger banks from using federally insured deposits to support speculative activities in both securities and derivatives. By prohibiting banks from dealing for their own accounts, the Volcker Rule prevents banks from manipulating credit spreads during the process of making a loan or underwriting securities for a client.
If you think that such blatant conflicts are a rare and remote issue in the global financial markets, think again. The temptation for a bank to put a finger on the scale during the underwriting process is too great. By separating the client activities such as lending and securities underwriting from principal trading for the bank’s account, the Volcker Rule addresses one of the most pernicious and least-discussed problems in the world of finance.
So how do we address the very real problem of market liquidity without returning to the bad old days when universal banks could both lend to and trade the credit products of a client?
First, the administrative requirements of the Volcker Rule are byzantine and should be greatly simplified as part of a larger review of rules regarding liquidity and other Dodd-Frank and Basel III regulations. The process for implementing and reviewing compliance with the Volcker Rule is excessively complex, costly and burdensome for banks. Congress also needs to focus on how the Volcker Rule interacts with the Basel III liquidity rules. Small banks should be entirely exempted from the provisions of the Volcker Rule.
Second, the restrictions of the Volcker Rule should be confined to the depository institutions of large universal banks. The affiliates of bank holding companies such as broker-dealers and funds should be allowed to trade for their own accounts. All trading of credit products, including securities and derivatives contracts, should be conducted via a broker-dealer. The conflict-avoidance language in the Volcker Rule, however, should remain in effect.
Adequate safeguards to isolate the depository from conflicts while still allowing nondepository affiliates to trade for their own accounts would alleviate the market liquidity concerns that have existed since the Volcker Rule was implemented. And shifting the derivatives dealing activities away from the bank would address public concerns about government support for speculative activities.
By retaining the Volcker Rule but revising it to address liquidity concerns, the Trump administration could achieve many of the goals of restoring Glass-Steagall while correcting a key problem created by Dodd-Frank.