In Defense Of The Volcker Rule
Some version of Wall Street reform is going to pass the Senate this week. The question now is how strong that reform will be. There are still three crucial battles to be waged, all of which would significantly change the way Wall Street does business. We will not fix Wall Street with this round of legislation, but we can reduce taxpayer exposure to bailouts and rein in consumer banking abuses. I'll address the Volcker Rule in this post, and tackle consumer protection and derivatives issues later this week.
One of the most important battles in the next few days will be over the Merkley-Levin amendment, which would require regulators to implement some version of the Volcker Rule. The Volcker Rule would ban economically essential commercial banks from engaging in reckless proprietary trading. "Prop trading," as it is known on Wall Street, allows banks to gamble with taxpayer funds by making speculative trades in the securities markets with taxpayer-guaranteed deposits. It's economically inefficient, it establishes grotesque conflicts of interest between bankers and their clients, and creates big bailout bills when the bets backfire. We want commercial banks to be doing important economic work like making loans. We do not want them to be taking on totally unnecessary risks in the pursuit of short-term profit, and prompting epic bailouts when that risk backfires.
The existing Senate language crafted by Sen. Chris Dodd, D-Conn., is not strong enough to end the excesses inherent in prop trading. Dodd would require regulators to conduct a study of whether prop trading by commercial banks endangers the economy, and then allow—but not require—them to write regulations to fix any problems.
Merkley-Levin, by contrast, would force regulators to ban prop trading by commercial banks, and establish a set of criteria that future regulators could not legally evade. While regulators would have some leeway in defining key aspects of the rule, they would have much less authority to impose weak rules than they have under Dodd's language. Merkley-Levin is a significant step in the direction of economic progress, but it has sparked some recent debate in the financial blogosphere, earning the ire of the Economics of Contempt (EoC) blog, which in turn has lead economist and blogger Mark Thoma to question the ultimate usefulness of the amendment.
EoC is wrong. Merkley-Levin is a very significant piece of legislation, which is why the GOP is threatening to filibuster it. EoC alleges that there are three fatal loopholes to Merkley-Levin. To my mind, none of them are important, and one is just flat wrong. I'll address them in order of simplicity.
First, EoC claims that Merkley-Levin would allow banks to simply move all of their prop trading offshore, citing legislative language that would permit:
(G) Proprietary trading conducted by a company pursuant to paragraph (9) or (13) of section 4(c), provided that the trading occurs solely outside of the United States and that the company is not directly or indirectly controlled by a United States person.
EoC has misread the provision. The second half of this sentence explicitly prohibits banks from moving their prop trading offshore. The key language is "not directly or indirectly controlled" by a U.S. bank. If Citigroup opens a London subsidiary to do its prop trading, that will be illegal, because Citigroup, a U.S. company, controls the subsidiary.
On to the next alleged loophole. EoC claims:
Merkley-Levin actually weakens the Volcker Rule by creating a whole bunch of new categories of exceptions to the prop trading ban . . . (1) trades 'in connection with underwriting'; (2) market-making trades; and (3) trades 'in facilitation of customer relationships.' Regulators still have to use the rulemaking process to define 'market-making,' which will no doubt encompass any trade which can be justified as a hedge against any risk the bank faces in its trading book.
First, it is simply not the case that this language actively weakens the Volcker Rule. While some key definitions are left for regulators to work out on their own, this is still better than the existing Dodd approach, which amounts to: "Please regulators, conduct a study." Dodd opposed the Volcker Rule from the get-go, and that's why his language is exceptionally weak. EoC's alternative to the Merkley-Levin language simply doesn't make sense—he says regulators—the people he doesn't trust to flesh out Merkley-Levin—should have broad leeway to write their own rules:
People often ask why I say that complicated financial regulations can't be written at the statutory level. The reason, sorry to say — which Merkley-Levin demonstrates quite well — is that Congress sucks at writing complicated financial regulations.
Here's the problem: If regulators are hellbent on interpreting Merkley-Levin in a way that would gut the substance of the reform, then they certainly aren't going to get tough on prop trading with the much broader Dodd language, which just lets regulators do whatever they want.
On to the third alleged loophole. The legislation allows for, "Risk-mitigating hedging activities designed to reduce risks to the banking entity or nonbank financial company." EoC says this gives banks broad leeway to claim that proprietary trades are really legitimate hedges against risks in other aspects of the bank's business—even when that business is in another subsidiary of the bank.
This is much ado about nothing. If regulators really want to say that a prop trade is a useful hedge, this so-called loophole won't make it any easier to stop them than the Dodd language would. In other words, if regulators do not want to enforce the law, no legislative language is going to stop them (see Alan Greenspan, mortgage fraud).
The closest we can come to protecting the financial system against bad regulators is to follow the advice of Nouriel Roubini and others, who argue that Congress should ban economically essential commercial banks from engaging in any securities underwriting, market-making or derivatives dealing activities whatsoever. Commercial banks were barred from these businesses when the Glass-Steagall Act was in effect from the 1930s into the 1990s, and throughout that era, banking was a perfectly profitable and competitive business that did not require massive and costly bailouts.
Ultimately, we should reinstate Glass-Steagall. But that doesn't mean that Merkley-Levin should be rejected. At this point, it is clear that Glass-Steagall is not going to be seriously considered during this legislative cycle, and the Volcker Rule would still empower good regulators to go after one of the most dangerous forms of financial recklessness. If Congress approves Merkley-Levin, the Volcker Rule would immediately become law. Without the amendment, we'll have to wait for a study, and wait for the heads of various regulatory agencies to agree on whether proprietary trading is even dangerous, a process that has been designed to prevent the Volcker Rule from ever being finalized. Nothing can completely immunize the financial system against bad regulators. But Merkley-Levin does about the best job possible to make the Volcker Rule a regulatory reality.
Next up: Blanche Lincoln's derivatives bill.