The Volcker Rule: Unworkable and Unwise
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The last two years have seen the publication of numerous detailed and sometimes thoughtful financial reform proposals by the US Treasury, various financial regulators, leading members of Congress, independent groups and academics. Now, suddenly, a new idea for reform has emerged from the White House – prohibiting proprietary trading in bank holding companies. Of course, it is not really a new idea; rather it is one of Paul Volcker’s very old ideas which he is trying to resurrect in the current up-for-grabs policy environment.
Might it make sense to limit the extent of proprietary trading at banks? Is proprietary trading part of the set of core activities that should occur within bank holding companies, or would society be just as well-served by having hedge funds or others replace bank holding companies’ proprietary trading platforms? Is there a good reason for large, global banks to engage in proprietary trading?
Most academic studies of banking have little to say about what large, global banks actually do, much less what they should or should not do. The key problem has been a lack of data. There aren’t enough global banks to study their financial performance and strategies with much statistical precision, and the financial data they report are not very helpful in tracing the particular activities they engage in, or in explaining exactly how they make their money.
Consequently, most banking studies unhelpfully lump together large and small banks, and aggregate together their various sources of income, as if they were coming from similar activities despite the fact that their operations are as different as cheese and chalk.
Small banks essentially borrow deposits and lend to businesses and consumers, and derive most of their income from net interest and fees related to deposits and loans. The economies of scale in that business seem pretty small, and there is no obvious reason to combine that business with proprietary trading.
Large banks, however, are in an entirely different business, one in which intangible assets – consisting of scarce and valuable human resources, technological capabilities and valuable relationships with global clients – drive most of the earnings of the bank, and most of its core competency. Global banks execute transactions for clients in hundreds of products and services in markets all over the globe, and also offer strategic and tactical advice about clients’ finances. Global banks are repositories of strategic and tactical knowledge that clients call upon regularly to help shape their business strategies. Global banks, to a large extent, are the financial brain of the global economy. Unlike small banks, global banks have to be big and diverse in their activities because their clients’ needs are diverse and global in scope.
Where does proprietary trading fit in to the core business plan of a global bank, and what would be the consequence for their clients of prohibiting it? Suppose it were possible to distinguish proprietary trades a bank made at the behest of clients from those undertaken at the initiative of the bank, and prohibit the latter category of proprietary trades. I doubt that it would be easy for regulators to fashion such a rule, but would it be desirable to do so?
First, in executing clients’ transactions, global banks physically have to take positions in their own books. For example, a client seeking to hedge a foreign exchange risk may sign an FX swap with his banker; then the banker aggregates its overall swap and other FX positions at the end of the day and determines how much of the net risk it has taken during the day should be laid off in the related futures markets, depending on the size of the net risk exposure and the costs of laying it off. Or a bank that is underwriting a municipal bond may provide price support to the issuer (by purchasing debt in the market as needed after the offering) to reduce fluctuations in market prices. In both cases, banks have to take positions during the day to be able to fulfill their clients’ needs, and banks need to be able to manage the risks related to these businesses flexibly, which means that it would be very difficult to fashion rules describing exactly how much risk banks would be permitted to undertake in the interests of their clients.
Even if it was possible to fashion such a rule, limiting banks’ proprietary trading to only covering clients’ needs would hobble global banks’ abilities to serve their clients. Banks do not just execute transactions that clients have already decided to undertake; they also advise clients on what to do, and how and when to do it. Clients rely on bankers to help guide their hedging strategies, or their capital raising strategies. Bankers help clients figure out when to do what, to what extent, and with which financial instruments. Bankers are able to do this because they have full knowledge of financial products and services that are available in the many different global markets, are acquainted with their risks and rewards, and see how those risks and rewards vary in real time.
Clients have confidence that their agents in the market are informed and experienced, and are able to get the best outcome for the client. The source of that confidence is simple: the person sitting at the bank trading desk is not a bureaucrat, but a highly paid financial expert. In order for the bank to afford to pay such a person, he or she must be creating value for the bank related to his or her knowledge of the markets, and the obvious way such an individual creates that value for a bank is by using knowledge of the markets to take positions for the bank.
In other words, prohibiting banks from proprietary trading would force banks to rely on relatively uninformed people to advise and execute for clients. Clients would never stand for this, and they don’t have to; they would simply switch to banks located in countries that permit bankers to be smart. The Volcker Rule would lead to a massive exodus of global clients to banks based elsewhere. Indeed, our own banks would likely move their operations abroad to avoid the Volcker lobotomy.
Client-driven economies of scope are not the only reasons why the “Volcker Rule” would be counterproductive. It is a profound irony that Paul Volcker sees lending as the proper function of large banks but not trading. For the most part, bank lending nowadays is largely real estate lending, an activity that was considered too risky for national banks for the first fifty years of their existence. The politics of getting agricultural interests to agree to the Federal Reserve Act led to a relaxation of the prohibition on real estate lending by national banks in 1913. Subsequent disintermediation from banks has created high concentrations of real estate lending in the banking system, and has produced a very undiversified income base for US banks.
Proprietary trading income and fee income derived from the highly diverse set of global products and services, which are closely related to global relationship banking, are among the primary sources of income diversification for the banking system. US banks are reeling from losses relating primarily to their exposures in residential and commercial real estate. No one would argue that that US banks would be less risky if they focused more on residential and commercial mortgages. And yet, that is precisely what the proposed ban on proprietary trading would accomplish.
There is a legitimate concern that some US banks, especially large ones, abuse their “too-big-to-fail” status by taking excessive risks. But it would be foolhardy to argue that prohibiting proprietary trading would solve the too-big-to-fail problem, just as it would be foolhardy to argue that prohibiting mortgage lending would end too big to fail. Reforms to address too big to fail need to focus on higher capital requirements, credible bank resolution policies, and reliable real-time means of measuring the risks taken by banks. It is high time to put political gimmicks aside and return to the serious debate over meaningful financial reform.
Charles W. Calomiris is Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business and a Professor at Columbia’s School of International and Public Affairs. His research spans several areas, including banking, corporate finance, financial history, monetary economics, and economic development.