Regulation and The Volcker Rule
If you’ve been running both a prop desk and a bank out of your garage these past few years, you’ve probably already read all about the new Volcker Rule. Matt Levine at Bloomberg has what seems to me to be an excellent and fair-minded take on the final version. It’s worth checking out in full, but the too-long-didn’t-read version is something like: for a rule that tries to do a pretty dumb and ambiguous thing (ban prop trading), it goes about it fairly intelligently.
But more interesting than the rule itself is the coverage the rule has received and the odd cognitive disconnect it reveals regarding the effects of the Volcker Rule specifically and regulation more generally.
Here is Reuters’ description on December 10th:
The measure known as the Volcker rule was a late addition to the 2010 Dodd-Frank Wall Street reform law and seeks to ensure that banks can’t make speculative trades that are so large and risky that they threaten individual firms or the wider financial system.
This is the White House release on the Volcker Rule from the same day:
The Volcker Rule will make it illegal for firms to use government-insured money to make speculative bets that threaten the entire financial system, and demand a new era of accountability from CEOs who must sign off on their firm’s practices.
And this is a post from New York Magazine‘s Kevin Roose on the rule’s effects:
The Volcker Rule pushed all of those units out of banks, and most of their employees ended up in hedge funds and private-equity firms. That’s exactly what was supposed to happen – a transfer of risk away from too-big-to-fail, FDIC-backed banks to parts of the industry that could absorb losses more cleanly.
In all of these quotations is the bizarre linkage between prop trading, too-big-to-fail, and the 2008 financial crisis. The image of an evil cigar-smoking banker playing roulette with your and my savings accounts and then leaving Uncle Sam with the tab when the bet goes bad is appealingly populist, but it’s also pretty divorced from the reality of five years ago.* The crucial moment in the crisis was Lehman Brother’s bankruptcy, and they weren’t even a deposit-taking institution (neither was Bear Stearns). And the systemic importance that makes banks too big to fail isn’t connected to their retail banking operations; it’s the result of their role providing short-term financing to corporations, business loans, hedging facilities, etc. Limiting prop trading may get at “too big”, but it’s not clear it does so in a way that has any real implication for “to fail”.
Beyond, in my mind, being something of a non-sequitur to the 2008 crisis, Volcker and the way it’s covered pay little heed to the actual costs associated with adhering to regulation once it’s passed.** If your concern is banks that are too big to fail, adding to their regulatory burden is a strange way to go about addressing it – all you’ve done is encourage concentration as smaller institutions find themselves unable to cope. It is true that Volcker specifically seems to have made banks smaller by forcing them to close their prop trading desks, but systemic importance (which is the real arbiter of too-big-to-fail status) is as much a function of concentration in a particular sector as it is sheer size. Levine doesn’t seem to think complying with the Volcker Rule will require banks to substantially change how their trading desks operate, but after reading this summary of the specific compliance demands it seems difficult to imagine their regulatory burden won’t increase at all.
The Volcker Rule may not, by itself, have particularly deleterious effects on the American financial system. And its drafters deserve credit for taking a holistic approach which doesn’t seek to assess the prop-iness of thousands of individual trades – imagine the potential market distortions that would create. But it’s also difficult to tell precisely what Volcker’s knock-on effects might be, and how they might affect the market in five or fifteen years. For example, you can, without too much exaggeration, draw a regulatory line that starts with Enron’s collapse and ends at Twitter’s IPO. Sarbanes-Oxley imposes a regulatory burden small growth companies (especially in the technology sector) aren’t capable of meeting, IPOs collapse, Congress responds with the JOBS Act, and Twitter takes advantage of the emerging growth companies exemption to go public with a confidential filing. I doubt anyone saw that coming in 2002.
We don’t, as a species, seem to excel at predicting the effects of expanded regulatory burdens, and when we do realize what they are, our response frequently generates a cascade of additional regulation (and its attendant unexpected consequences). That’s not necessarily an argument against the Volcker Rule, but it does suggest we probably should be holding our breath when it comes to truly understanding its impact.
*Look! Tyler Cowen agrees (see #3)
**I suppose, “right after a financial crisis” is a good time to enact financial legislation, and Volcker is only one part of the more-broadly relevant Dodd-Frank, but still