The Big Banks don’t like the Volcker Rule. For reference, and so we’re all talking about the real thing, here’s the little culprit: The Volcker Rule “separates investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms. Banks are not allowed to simultaneously enter into an advisory and creditor role with clients, such as with private equity firms. The Volcker rule aims to minimize conflicts of interest between banks and their clients through separating the various types of business practices financial institutions engage in.” [investopedia]
We can simplify this further. A bank, insured by the FDIC, may not combine their proprietary trading activities with their consumer lending ones. And, why do we need the Volcker Rule?
“The Volcker Rule seeks to keep activities essential to banking within a safety net, while excluding other, riskier, activities from this safety net. There are a variety of special regulations, and protections, banks get, ranging from federal deposit insurance (known as FDIC) to access to the Federal Reserve’s discount borrowing window, designed to keep the system working through panics. Banks currently engage in a wide variety of non-banking activities with safety net protection. For example, they speculate in currencies and run hedge funds and proprietary trading desks for their own benefit. These activities made the financial crisis worse; one estimate has the major Wall Street firms suffering $230 billion dollars in prop trading losses a year into the crisis. And right now, these activities are subsidized by access to the banking safety net.” [Nation]
So, the message to the Big Banks is relatively clear: Your consumer lending activities on behalf of your clients are covered by the “safety net” (FDIC coverage or access to the Fed’s discount window) BUT your hedge funds and proprietary trading desks aren’t.
Slicing and Dicing
Opponents of the implementation of the Volcker Rule make some basic points, all of which deserve more scrutiny. (1) They argue that the rule making process is creating “uncertainty” because we don’t know what the final rules will be. The word “tautology” comes to mind because this argument circles back on itself nicely, as in ‘ we can’t make rules because while we’re drafting the rules we don’t know what the rules are.’ If we applied this argument to any other phase of life there would never have been any rules.
Here is an example of the tautological thinking:
“Since neither the banks nor the regulators have any idea what the final regulations will say, they will have no idea what constitutes good faith efforts to comply. Because of the continuing confusion and its effects on the financial system, Congress should immediately begin a serious re-examination of the Volcker Rule’s likely effect both in this country and abroad and repeal it as quickly as possible.” [Heritage]
Why bother to “seriously re-examine” the rule if the initial purpose is to quickly repeal it? Imagine for a moment waiting for Moses to return from the mountain. If our moral judgments aligned with the Uncertainty Proponents we’d not necessarily know that we shouldn’t dispatch each other because we’d have to know in advance if the Almighty intended to incorporate justifiable homicides or excusable homicides, manslaughters or negligent homicides, within the proscription of killing each other — and, further, we couldn’t have a Rule until all of these nuances had been properly phrased and found to be acceptable to all the stakeholders.
(2) A more cogent argument against devising regulations pertaining to the Volcker Rule asks: How do specific short term banking services apply to the separation of traditional banking and modern client services? At this point we get into the “liquidity” swamp.
Suppose the executives of SlamBang Corp. want to purchase some stocks for the purpose of generating some revenue for the firm by going to its banker and asking the bank to make the purchase, hold on to the stocks, and if the price of the stocks goes up then selling the stocks, and returning the proceeds of the sale to the SlamBang Corp? (Less, of course, the fees, commissions, etc. for the bank) Would this be a violation of the Volcker Rule?
Now we’ve waded into the edges of the Liquidity Swamp, liquidity being “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.” And, our next step takes us into “leverage.”
Leverage means the extent to which a company is operating on borrowed money. The good news is that if the company isn’t too far in debt it will be financially stable and lenders will want to make loans to it for a variety of very legitimate purposes. The bad news is that if it’s as underwater as a Sand State homeowner with a NINJA loan it will be bankrupt, and no one will want to lend the corporation another nickel. (Think Lehman Brothers)
Life can get messy if and when the SlamBang Corp. gets its revenue from making something tangible AND from making speculative bets in the equities markets — with borrowed money (like asking the bank to hold on to the “stuff” it bought until the price goes up.) The more the SlamBang Corp. is leveraged — borrowing money to make money — the riskier the entire proposition. Where will our SlamBang Corp. go to borrow more money to make more money?
Bankers, having set up sizable trading desks, or having once been one big trading desk (Goldman Sachs), were only too happy to transform themselves into bank holding companies for the benefit of their very own social safety net (FDIC coverage, Fed Discount Window, etc.) when they were collapsing like Macy’s Thanksgiving Day Parade balloons in a shooting gallery — now that they have returned to profitability they aren’t the least bit interested in returning to “core banking activities,” and divesting themselves of the revenue generating proprietary trading functions.
Re-enter the financial officers of the SlamBang Corp. into the lobby of the Big Bank. Under the terms of the Volcker Rule the Big Bank may not act BOTH as their adviser AND their creditor. What Big Bank fears at this point is that SlamBang Inc. will take its “speculation in liquid assets for the purpose of leveraging its position” elsewhere, to a private equity or hedge fund for example.
It’s important to notice at this point that SlamBang Corp. isn’t hurt by the Rule, it can easily send its business to an alternative source of credit or financial services — it’s the Big Bank that wants a fork in every plate on the table. Advocates of Big Bank say:
“The situation becomes even more confused if the bank serves as a “market maker” for a security. A market maker plays a vital role in ensuring the efficient running of financial markets by both buying and selling that security so that others can be assured of buying and selling opportunities, an activity that requires the bank to own a certain inventory of the security.” [Heritage]
Translation: Banks are now market-makers and market-makers have to own securities in order to be market-makers. The problem for our economic system is that when the “markets” are made by the banks, and those “markets” are extraordinarily speculative, AND the Big Banks expect the FDIC or the Fed to rescue them if the speculation goes south — then how best can we sustain the traditional functions of our financial sector in a capitalist system without allowing the Big Banks to put us all in jeopardy?
The Volcker Rule.