Inside Financial Services

The Misbegottenness of the Volcker Rule Truly Knows No Bounds

Next, get ready for upheaval in the fixed-income markets

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The indispensable Peter Wallison gets at why the Volcker rule is a disaster waiting to happen:

If we recall now that the Volcker rule prohibits banks from trading securities for their own account, we can begin to see the problem. Market-making sounds a lot like proprietary trading; the bank has a portfolio of bonds, which it is offering to buy or sell for its own account, but that’s the very definition of proprietary trading. How does one tell the difference between proprietary trading, which is forbidden, and market-making, which is vital to the markets and permitted by the rule? [Emph. added] Given that the Volcker rule is essentially a legislated oxymoron, it’s no wonder the thing runs to more than 1,000 pages and still isn’t especially clear in certain key areas.Nor is it a wonder, for that matter, that whether Congress exempted market-making or not, the big banks seem to all be cutting back on their market-making activities. Can you blame them? This fixed-income wind-down is going to cause all kinds of problems. As liquidity dries up, credit will become more expensive for large corporate borrowers. Insurers will have more difficulty efficiently funding their long-term obligations. Banks will lose a key source of revenue, as well as a source of diversification in their business mix. None of that is good.But the most profound effect of the coming disruption in the fixed income markets will also be the one lawmakers likely wanted the least: the Volcker rule will almost certainly drive a huge migration of institutional fixed-income market-making away of the banking arena and into the shadow-banking system, or what industry detractors like to call the unregulated “Wild West.” There’s money to be made in making markets, after all; if banks won’t do it, unregulated entities will. So here Dodd-Frank was supposed to re-regulate major pieces of the financial services industry, and it will instead have the effect of de-regulating one of the industry’s most important functions. Life certainly is full of ironies. This would all be amusing if it weren’t so ominous. I may sometimes come off as a laissez-faire banking zealot, but am actually as convinced as anyone that the financial services industry won’t work unless it’s properly regulated. (To put things another way, how do you think the 2008 crunch would have turned out had there had been no FDIC or Federal Reserve?) The crackup happened, recall, when things went haywire in another part of the shadow banking system: money market funds.Once the Reserve Fund broke the buck, a liquidity panic gripped the entire system and, absent an extraordinary intervention by Hank Paulson, everything would have ground to a halt. It’s obvious now how a liquidity crunch in the money market fund market can freeze the system. I’m having trouble seeing why a liquidity crunch in the institutional corporate bond market might not do the same thing. The Volcker rule is a disaster. Proprietary trading-the activity the rule seeks to ban-didn’t cause the credit crunch. Many other things did, most notably a rash of unhinged spree in subprime mortgage lending did. The rule will make banks less safe by effectively removing an attractive line of business for them, and will make the entire system less safe by removing a key industry function from regulators’ oversight. As I say, a disaster. What do you think? Let me know!

6 Responses to “The Misbegottenness of the Volcker Rule Truly Knows No Bounds”

  1. grover13

    Eliminating proprietary trading by banks will cause chaos, Tom? You mean like the chaos between the 1930s and 1990s when it was also illegal under Glass Steagal?

    Nice try, Tom. I’ll file this rallying cry right next to “if you raise taxes on job creators, it will kill jobs and cause a recession.”

  2. Barrydemo

    As a former Hedge Fund Trader, where am I going to get the liquidity to Trade?
    Agree with you.

  3. rivvir

    I’m with you Grover. Tom, you visiting grandma’s cottage today? Better run, little red riding hood started out 10 minutes ago.

  4. Rod

    I would assume that was the intent in the first place. this is the Obama administration is it not?

  5. oy

    Trading may be pushed to the shadow market, but thank God the shadow market participants aren’t guaranteed by the taxpayers when they make a wrong way bet. That is the whole point of the exercise, Tom.

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