Since the Great Recession wiped out over $19 trillion in wealth and nearly eight million jobs, Washington has cracked down on financial institutions in an effort to reduce system-wide risk. The Volcker Rule has emerged as one of policymakers' primary weapons.
Reasonable people can disagree about the extent to which Volcker will be effective at retaining good trading (market-making) while moving bad trading (proprietary trading) out of the banking sector. Achieving this goal will certainly be a challenge: the line between the two kinds of trading is a matter of subjective judgment, and regulators are relying on an independent community within the financial system nonbanks to step in and fill the liquidity gap.
While the Volcker Rule may curb future bank losses, it may also produce results that could exacerbate an economic downturn and undermine recovery. The deadline by which banks must comply with the rule is in 2015, but we are already seeing signs of its potential effects.
Since the rule was adopted last December, bank capital has moved decidedly away from fixed income, currencies and commodities desks. Banks are reorienting their trading platforms in response to the rule as well as other reforms that make these businesses more expensive to operate and less economically viable.
Thus far, nonbank solutions have either provided or are poised to provide some of the liquidity that has been displaced though not without some bottlenecks. In the rates and currencies businesses, technology is offering alternative trading mechanisms. Electronic trading platforms can allow buyers and sellers to trade directly with each other, cutting out the middlemen in some cases. On the currencies side, nonbanks, especially those outside of the U.S., have picked up some of the slack.
Net-net, the rule has produced the creative destruction that its backers intended, with nonbanks filling the gap.
However, the Volcker Rule assumes that creative destruction always will work seamlessly. History suggests otherwise. Major structural transitions are messy, and relying on nonbanks which are subject to fewer controls requires some amount of luck. Nonbanks have been known to exit certain businesses in an abrupt manner just when the market needs liquidity most.
The fact is that banks' move away from risk could exacerbate price declines into a downturn. Consider how the rule might impact the system as market indicators trend downward. Taking the moderately-sized commercial mortgage-backed securities market as an example, let's say that spreads break out of their long-time tightening pattern at the same time that lending criteria get more adventurous. Both trends are underway, so this scenario should not be too difficult to imagine.
Under the Volcker Rule, regulators will have to draw the line between good and bad risk market-making versus proprietary trading. But as trading businesses suffer volatility and deterioration, good positions (acquired because a bank knew that a buyer would come into the market soon) may look and function like bad positions (in which there may not be a buyer imminently on the other side).
If regulators aren't sensitive to the difference going into a downturn, they could extract legitimate liquidity from the CMBS market. Good deals might not get done, and investors might encounter trouble shedding positions in the secondary market.
The potential negative impacts would be larger than the CMBS market's relative size suggests. Correlations rise when conditions sour, and liquidity moves in waves rather than ripples. In other words, the entire $3.2 trillion commercial real estate debt market could be adversely affected by the rule's treatment of CMBS.
To avoid such a result in commercial real estate finance and other market sectors, we must recognize that it is virtually impossible to surgically extract risk from the banking system and transplant it to the non-banking system. Therefore the importance of bank market-making should not be understated. Banks must be given latitude under Volcker to maintain necessary inventories.
The rule thus far has reduced leverage in the banking system, even before it has been fully implemented. How the regulators treat this next, more critical phase of implementation will determine whether it actually makes our financial system riskier on balance.
If regulators take an overly aggressive approach to defining the line between good and bad trading, the rule could make the financial system more rigid and less capable of absorbing stress. Certain markets may not be able to function efficiently without sustained support from traditional market-makers, with serious implications for the broad economy.
Fortunately, Volcker provides regulators with some leeway to minimize its potentially negative impacts on market-making trading. Let's hope banks and regulators recognize the importance of avoiding an overreaction to Volcker, especially in a downturn. Otherwise, overly negative feedback on pricing could encourage asset sales into a falling market and actually accelerate a downturn. That would defeat the whole purpose of the rule by draining the very liquidity from the system that is required to ensure its health.
Christina Zausner is vice president of industry and policy analysis for the Commercial Real Estate Finance Council in Washington, D.C.