Politics & Policy

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.”

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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