The Volcker Rule, enacted as part of the Dodd-Frank Act in 2010, has lately received a lot of adverse commentary. The complexity of the draft-implementing regulation, and the clear indication in the regulators' questions that they did not know how to make the rule work; has produced a new round of criticism. But that's only one of the problems this rule creates, and a relatively minor one.
Although the rule was sold as prohibiting banks from using insured deposits to fund risky trading, the act covers "bank related entities," which includes bank holding companies and their subsidiaries, from engaging in proprietary trading for their own accounts. These entities are ordinary corporations, and fund themselves in the capital markets by issuing debt and equity. They don't take deposits. It's unclear why these companies are excluded from engaging in a financial activity, when other corporations and hedge funds are not.
It was never clear what proprietary trading had to do with the financial crisis, in which banks got in trouble for buying and holding securities backed by subprime and other low-quality mortgages. There is no indication that trading activity before the financial crisis caused any significant losses among banking organizations. In many cases it was a source of substantial profits. Since bank holding companies are supposed to be sources of strength for their subsidiary banks, it's peculiar that they've been deprived of a profitable financial activity that would allow them to perform that role.
It should be obvious that if bank holding companies and their subsidiaries are restricted to the limited activities permitted to insured banks themselves, they cannot be more profitable than their deposit-taking subsidiary banks-becoming then a source of weakness rather than strength.
It is not well understood among American policymakers that the business of banking has been declining in importance in the U.S. financial system for at least 40 years. The growth and efficiency of the securities markets has made it possible for companies registered with the SEC to meet their long and short-term funding needs largely by issuing bonds, notes, and commercial paper in both private and public offerings. This is often much less expensive than borrowing from a bank and almost always involves fewer restrictions and administrative costs. As a result, large banks that would normally have lent to corporations have been forced to look for borrowers who do not generally have access to the securities markets. This has forced them increasingly into lending to real estate developers and other real estate related activities. Thus, in 1965, less than 25% of bank lending was to real estate, but by 2005 that number was 55% and still rising. Real estate is a notoriously volatile activity, so as banks become more closely tied to that business, we can expect that real estate recessions will turn into bank crises.
This is relevant to restrictions on proprietary trading because that activity (not real estate related) can produce income for banking organizations. Every time we take another profitable business away from the banking industry we weaken the industry further and make it more likely that we will have another banking crisis in the future. The 2008 crisis came about because banks had bought and held large amounts of mortgage-backed securities based on subprime and other risky loans. Would that would have happened if banks were still able to make loans to corporate America? The fact that the securities market has out-competed the banks for corporate business is certainly not something to regret. This is Schumpeter's creative destruction in action. If corporations can finance themselves more efficiently in the securities market, they can spend more on innovation and growth. The problem is that regulations like the Volcker Rule are a throwback to a world that is gone. It attempts to confine banks and their holding companies in a regulatory straitjacket that is inconsistent with the changing world of finance that new technology has created. While many other financial institutions will be able to innovate, banking organizations are frozen in time-forced to live in a world that began to fade away in the 1960s. The Dodd-Frank Act contains many examples of this desire to impose old standards on a new reality. Now, there are many calls for repeal of the act. Whether this will occur depends on the results of the 2012 election.
But, if we hope to have a viable banking industry in the future, the Volcker Rule, among many other provisions of the act, should be revisited now.
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