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


Regardless of how narrowly or broadly we define it, prop trading by commercial banks and BHCs was not a root cause of the 2008 financial meltdown. (The impact of prop trading by non-bank firms is a separate issue.) Even if a muscular version of the Volcker rule had been established prior to the crisis, “it wouldn’t have made a difference in the least,” says Council on Foreign Relations economist Benn Steil, a member of the Pew Task Force on Financial Reform. “The crisis had nothing to do with deposit-taking institutions engaged in proprietary trading.”

Advocates of the Volcker rule stress that it is designed to forestall the next crisis, rather than to address the origins of the last one. That’s a fair point. But a blanket ban on prop trading by government-guaranteed depository institutions could bring a host of unpleasant results. “A complete prohibition of certain activities — activities that are perhaps more risky but not necessarily economically inefficient — is a very far-reaching market intervention,” German central-bank president Axel Weber told an audience in Dublin on March 10. He predicted that it “might have unintended and unfavorable consequences,” such as “undesirable effects on the transmission of monetary policy.” Citing evidence from Europe, Weber also suggested that “universal banks with a broad range of business can also be a stabilizing factor during a crisis.”

As Steil observes, “Nobody can make the argument that prop trading is inherently more risky than commercial-real-estate lending” — yet Congress is not about to forbid the latter. If a bank has a market-making capability in order to conduct customer business, he adds, it will need to be profitable. Therefore, government officials will find it “difficult, if not impossible,” to distinguish between (1) speculative activities aimed at serving the bank’s customers and (2) speculative activities aimed at boosting the bank’s profits. “I don’t think you can implement any sort of Volcker rule without giving enormous discretion to the regulators,” says Steil. “And that scares me.”

University of Chicago financial economist John Cochrane agrees that broad regulatory discretion can be dangerous — it can send moral hazard “way off the charts” — but he also favors the basic thrust of the Volcker rule, since prop trading can dramatically increase or camouflage an institution’s risk exposure. Precisely because it is so nebulous, he urges Congress to formulate specific legal guidelines that allow very little room for arbitrary decisions by Washington bureaucrats. The task may seem daunting, but Cochrane believes it is possible for federal legislators to differentiate prop trading from other banking functions. Are they up to the challenge? We may soon find out.

Duncan Currie is deputy managing editor of National Review Online.


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