The Volcker rule included in the Dodd-Frank Act was intended to eliminate "proprietary trading" at universal banks. This was largely motivated by the massive losses incurred by the proprietary trading desks of Wall Street investment firms that securitized mortgages. In the rush to mitigate systemic risk in the wake of the subprime lending debacle, banking charters and the Fed's protective umbrella were extended to the remaining investment banks. The thinking was that trading is risky, and hence not appropriate for insured banks, but establishing rules to prevent trading at universal banks was never going to be easy.
The Glass-Steagall Act of 1932 separated commercial banking and deposit-taking from securities underwriting and market-making activity, extended the prohibition against branching across state lines to federally chartered banks and established the Federal Deposit Insurance Corporation to protect small depositors. As any insurance creates the potential for moral hazard, i.e., the incentives for managers and shareholders to take excessive risk, the FDIC became an independent federally sponsored prudential regulator to mitigate this risk.
Glass-Steagall was mostly a counter-productive law and only deposit insurance remains. But the investment banks that have now come under the federal protective umbrella as universal banks are much different than those spun out of commercial banks eight decades ago in three very important ways.
First, they don't just hold and trade dealer inventory. The largest firms at the time of the financial crisis managed trillion dollar balance sheets of mostly hedge fund (and private equity fund) positions, which is referred to as "proprietary trading," i.e. speculating for the benefit of the trader and firm.
Second, until relatively recently investment banks were owned and managed by the partners, with the investment banking managers taking a long view (their lifetime, as their wealth capitalized the firm) of customer relationships and trading risk. By the time of the financial crisis those not already absorbed into universal banks were all shareholder owned and run by traders, for whom a minute is an eternity and an all-cash bonus at year end is a necessity.
Third, they don't just peddle stocks and bonds of unrelated third parties. During the subprime lending debacle, they created the mortgage backed securities and collateralized debt obligations that funded it, peddling theses crappy securities to investors while making huge fees. A lot of the most toxic securities were held in their so-called proprietary trading accounts, but these securities generally weren't traded, as most of them weren't worth close to the value placed on them, if anything. But the up-front profits from securitization made their ultimate value irrelevant. Accounting valuation rules hid the likely loses for years, and the traders made multi-million dollar bonuses based on fictitious accounting yields in the meantime.
So the Volcker Rule doesn't address the mislabeled "proprietary trading" problem of the last crisis, and instead bans what was usually profitable trading activity. Moreover, Dodd-Frank didn't address the problems that arise when traders run the bank and didn't change the role of universal banks in providing capital market access for mortgages (or other assets).
Whatever mortgage model emerges, universal banks will continue to create and sell securities in which they retain a first loss interest, so the problem of valuing the retained interest remains. If they follow the European covered bond model, covered bonds will be treated as a financing and banks will remain on the hook should the mortgage collateral prove insufficient.
Politicians were most agitated by Goldman Sachs shorting the subprime market while still peddling sub-prime securities, and there is legislation pending to prohibit this practice. But from the perspective of their shareholders — and hence now the deposit insurance fund - both activities were beneficial. Selling the subprime inventory before the market dried up was hugely beneficial to the sellers, not so for the buyers. And their speculators shorting the market provided Goldman with a good portfolio hedge, which is why they weathered the sub-prime lending debacle better than the other investment banks.
But one trader's hedge is another's speculation, and regulators and accountants have historically had a difficult time distinguishing the two. First, they have required the two trades to be "matched" to qualify for hedge accounting. Second, they require a high degree of negative correlation between the "hedge" and "long" position. Otherwise, they impose "the lower of cost or market," i.e. take the hedge (or long) position loss but not the long (or hedge) position gain, perversely discouraging "portfolio hedging," i.e. speculative positions that reduce the volatility of a firms economic net worth.
The Volcker Rule is the right idea. Universal banks are much more thinly capitalized than hedge funds, although SEC rules allowed wildly excessive leverage at investment banks, much of it funded by commercial banks, during the subprime lending debacle. So divesting internal hedge fund activity from shareholder owned universal banks as the Volker rule is intended to do is appropriate.
But Dodd-Frank doesn't fix the mortgage risk problem that motivated the Volcker rule in the first place. Mortgage risks may still be excessive as resolving the political debate regarding risk retention rules and QRM to keep mortgages "affordable" has been assigned to the Consumer Financial Protection Bureau to resolve.
In this overly politicized regulatory environment in which the regulatory focus is on borrowers and investors, banks may well find easier ways to speculate with depositor money within the proposed Volcker Rule than to hedge their balance sheet.
Kevin Villani was senior vice president and chief economist at Freddie Mac from 1982 to 1985.
