Volcker Rule May Not Be the Right Rule

Jeff Madrick

President Obama’s decision to support what is now called the “Volcker rule” has opened up a Pandora’s box of difficult issues—and may yet force policymakers to face some hard truths. It is unlikely the president fully understood that this would happen.  What’s less likely is that some on his economics team didn’t understand.  Increasingly, there is a sense that the combination of the old Clinton guard, most of them deeply linked at one time or other to the banking community and the deregulation movement itself, and a somewhat conservative University of Chicago group of Washington newcomers, led by Austan Goolsbee and Cass Sunstein, are not providing the president a full plate of options or adequate analyses of those he does get.

Questions of potential infighting aside, the central issue is whether and how to separate banking activities.  In the U.S. these activities had long been divided by New Deal legislation, led by the Glass-Steagall separation of underwriting and brokering from business lending.  Once the Federal Deposit Insurance Corp. had been created to insure savers’ money, it was predictably decided that what bankers could then do with that money should be circumscribed. Aside from the basic Glass-Steagall divisions, there was also a limit placed on how much bankers could charge to lure savers’ deposits, known as Regulation Q. The purpose was to restrain runaway competition for deposits, which could induce bankers to take chances on making higher-payoff investments.

The assault on Regulation Q began with Walter Wriston’s negotiable CD in 1966, started at First National City, later Citicorp and ultimately Citigroup.  Regulation Q was completely set aside in 1980. The dismantling of Glass Steagall began in the 1980s when Alan Greenspan’s Fed allowed investment banks to underwrite debt issues and, a few years later, equities.  All the while, of course, European nations proudly supported the advantages of universal banks. Eventually, to meet that competition, influential bankers like Sandy Weill, head ultimately of Citigroup, demanded that Glass Steagall be scrapped altogether.  Led by Robert Rubin, the Clinton Treasury Secretary and later a well-paid employee of Weill’s, the administration did just that in 1999.

Now Paul Volker, who always favored tougher banking regulations than his Republican employer, Ronald Reagan — which is one reason he lost his job to Greenspan in 1987 — urges a return to a separation of banking tasks. They are “too big to allow to fail.” Others are joining him, notably Mervyn King, the former academic economist and head of the Bank of England.

But how does one do this?  There have been disappointingly few serious analyses of how to go about it. Volcker’s main objective is to keep banks that have access to reserves at the Fed window, and to trillions of dollars of federally insured deposits, from making speculative investments.  This makes the system too risky. Maybe more to the point, and less well stated, even by him, it will make the banks less susceptible to the speculation of unconstrained investment banks, hedge funds and others, who can bid up or down prices on securities like collateralized debt obligations to absurd levels.  If those securities fall in price rapidly, Volcker presumably hopes, the big deposit-taking institutions will no longer fall with them.

But for some inexplicable reason, Volcker thinks this can be accomplished by disallowing so-called “proprietary” trading at the deposit-taking institutions.  Banks should only take major directional positions when trading for customers, he argues. Either he is naïve, wants to get at least some prohibition on the banks, or is being rolled by the industry and perhaps even Obama’s economists.  Talk from England about how to split bank functions is also nebulous. The problem is that the proprietary trading is not where the banks take their biggest risks. The trading desks of commercial and investment banks, which ostensibly trade for customers, speculate all the time in huge volume.  This is not considered formal proprietary trading, but in reality it is just that.

I am told off the record that Henry Kaufman, the octogenarian former economist of Salomon Brothers, as well as John Reed, the former head of Citibank before the merger with Sandy Weill’s Travelers, wants to disallow speculative position taking on trading desks as well—maybe prohibit banks from making these markets altogether.  But that is a radical position that perhaps Volcker realizes is impractical.  The banks make too much money; they will fight this to the end.

The point is that American reformers are simply not facing the facts. They want to get by with moderate increases in capital and liquidity requirements on these banks and little more. If they break them up, it will be only modestly.  Speculation will continue; dangers will arise again.

What is equally disturbing is that policy is being made, as far as this observer can tell, without a real analysis of how this trading works.  One journalist quoted a member of the Treasury team working on the project as saying he is talking to everyone. Talk is cheap and often deliberately misleading. Analysis takes real research, and some serious demands for data are required.  Is the Obama team doing that? Is the Bank of England doing that?

Consider some of what we know publicly about speculating on the trading desks of investment firms, most of which are now part of commercial, deposit-taking institutions.  When Lewis Ranieri started the mortgage trading desk at Salomon (now part of Citigroup), which soon led to mortgage securitization, he bought huge amounts of mortgages for Salomon’s own account, disturbing his partners. When rates went down, he made them a fortune, and quieted the dissent. One of his traders, Howie Rubin, left to go to Merrill Lynch where, after making them a small fortune, proceeded to lose $300 million in a few days. Was this simply taking positions to support customers’ trading?  He was fired, but hired almost immediately by Bear Stearns.   Was Bear Stearns merely trying to service customers?   Ranieri also lost a bundle as did Larry Fink, who developed the collateralized mortgage obligation at First Boston. Both were also more or less forced out of their jobs.

These speculations were not made in “proprietary” accounts.  Does the Obama administration truly understand this? Does Volcker himself understand this?  The persistent search for acceptable reforms of Wall Street—that is reforms that don’t rock the boat too much—is the wrong path.  But it is the easiest path.  It is not clear that Obama yet realizes how difficult the job of serious regulation is needed. It is unlikely we will get what we need.