The Volcker Dilemma
Should the feds ban proprietary trading by depository institutions?


Of all the financial-reform ideas that have been entertained over the past year, few have aroused as much vigorous opposition on Wall Street as the proposal to outlaw or restrict “proprietary trading” (trading for profit) by commercial banks and bank holding companies (BHCs). Championed by former Federal Reserve chief and current Obama economic adviser Paul Volcker, this would effectively reinstate a portion of the 1933 Glass-Steagall Act, which was partially rolled back under the Clinton administration. Critics argue that the vagueness of proprietary trading (or “prop trading,” as it’s known on the Street) makes the so-called Volcker rule untenable. But supporters insist that new safeguards are necessary to block federally insured depository institutions from pursuing risky investment activities and having taxpayers cover the losses.

As congressional negotiators seek to merge two gigantic financial-regulation bills — one passed the Senate last month; the other passed the House in December — the Volcker rule remains a major point of contention. According to the New York Times, the negotiators “have largely agreed” to embrace tougher curbs on prop trading than those contained in either piece of legislation. But the exact details are still unclear.

Back in March, a smart friend on Wall Street e-mailed me with his general critique of the Volcker plan. “It’s difficult to characterize what prop trading is,” he said. If we adopt the most expansive definition of the term, does it include everything other than responding to customer inquires? If so, is a banker “prop trading” when he hedges against risk? “In many cases,” my trader friend explained, “we facilitate customer-driven inquiries even if we don’t necessarily like the trade, or the position it puts us in, so we have to cover back or hedge the position. Does a ban on prop trading [by commercial banks and BHCs] prevent a trader from having a directional or relative value view on any product? That would essentially kill liquidity and the concept of an efficient market.”

While it’s no surprise that Wall Street has tried to shield some of its most lucrative practices from government interference, questions like my friend’s are hardly mere self-interested obfuscation; coming up with an operational definition of prop trading does indeed present a thorny dilemma. During a Senate Banking Committee hearing on February 2, GOP ranking member Richard Shelby (Ala.) asked Volcker to clarify how regulatory authorities would be able to identify “excessive growth” in a given bank’s liabilities. Such growth is “like pornography,” Volcker quipped. “You know it when you see it.” His allusion to the famous Potter Stewart quote only reinforced the notion that prop trading is a murky concept. In his prepared testimony, however, Volcker declared that “every banker I speak with knows very well what ‘proprietary trading’ means and implies.”