After more than three years and some 18,000 comments from interested parties, the financial sector's major regulatory agencies are locked in battle over how best to implement the Volcker Rule. We wholeheartedly support the Volcker Rule, but fear that regulators are making the proposed regulations more complex than necessary or appropriate.
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, as we suggested in a previous BankThink post. We believe the time is right for regulators to take a more holistic view of the issues.
There is no evidence that proprietary trading caused or even contributed to the financial crisis of 2008-2009. But like many financial products, especially loans, there is substantial risk in proprietary trading. This risk should be carefully and intelligently monitored and regulated.
In writing the rule, regulators are essentially trying to answer: Is the risk of holding an inventory of securities to enable customers to readily buy or sell securities through a bank a reasonable amount or is it so excessive that changes in the market price of that inventory could put the institution in serious jeopardy?
Like any seller of products, it's perfectly legitimate and logical that a financial institution would hold more inventory of a product to be sold to customers if it expects the price might go up in the near future and hold less if it 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 get in 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 straight forward simply limit the amount of "trading" revenue as a percentage of the firm's total revenue to a de minimus level (say 10%). There is a precedent for this in the Federal Reserve's decision to limit investment banking revenue of Section 20 affiliates as a percentage of total revenue during the 1990s when the Glass-Steagall restrictions were still in place.
Monitor the trading results over time, and reduce the limit for any bank that consistently loses money on its 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.
A Volcker Rule limiting investment in securities used primarily for customer transactions to 10% of the firm's revenue, carefully monitored by regulators, is easy to understand and enforce. It will allow financial institutions to serve their customers in a safe and sound manner without placing the firms at risk of failing.
Should this approach prove inadequate in practice, regulators will always have the option of becoming more prescriptive and granular in their approach. Regulators should always operate under the premise that simple and easy to enforce is the best course until proven otherwise.
Richard M. Kovacevich is the retired chairman and CEO of Wells Fargo. William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is a senior managing director and global head of financial institutions at FTI Consulting, the chairman of Fifth Third Bancorp and author of Senseless Panic: How Washington Failed America. The views expressed are their own.