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Peter Wallison’s recent op-ed in defense of proprietary trading has generated a lot of controversy, particularly for his claim that proprietary trading is now good banking policy. But whatever you make of Wallison’s arguments, it’s hard to disagree with his conclusion that the current Volcker Rule is an unworkable disaster.
The current Volcker Rule was designed to fail because Republicans and Democrats inserted too many exceptions for their various constituencies and put far too much power and faith in regulators. Congress must either ban proprietary trading completely or repeal the Volcker Rule. Any effort to enforce the provision in its current form is a cynical charade.
The Volcker Rule was proposed to stop large financial firms from making risky investments that could threaten our financial system. The intention was to stop big banks from using their implicit government backing to amass huge proprietary trading positions and then make risky bets leaving taxpayers on the hook for losses if things went sour. Although proprietary trading didn’t play a large role in the 2008 crisis, politicians used the Dodd-Frank bill as an opportunity to pass the Volcker Rule to get ahead of what they argued could be the next crisis.
There’s clearly some merit to the concerns that the Volcker Rule was intended to address. Due to bankruptcies, consolidations, and mergers, a few large financial firms now control unprecedented amounts of money. And their risky activities, such as proprietary trading, pose an even greater threat to our financial system in this concentrated environment. The Volcker Rule was supposed to stop or mitigate some of this risk. But the Volcker Rule is practically worthless because of all the loopholes built into the provision by Congress. And both Republicans and Democrats are responsible.
For example, the Volcker Rule only applies to short term trading positions – long-term, multiyear investments are allowed no matter how risky they are. In other words, banks are allowed to make terrible investments as long as they span over a few years instead of a few months. Although Section 620 of Dodd-Frank gives regulators the permission to look through these assets, the limited resources of regulators and the practically unlimited assets of banks suggests this check will not be effective.
The subsection D “low-risk” exceptions to the Volcker Rule are even more problematic because U.S. government debt is exempt and other sovereign debt will probably be carved out as well. This is really a shocking development because one of the most important lessons over the past few years is that government debt is not risk free. Look no further than the European debt crisis for evidence.
The Volcker Rule also allows banks to engage in market-making activities, which basically allows banks to hold speculative positions while ostensibly looking for a buyer/seller. Because of this exemption, it will be difficult for regulators to separate true market-making functions from actually placing risky bets. Therefore, banks may ultimately be allowed to make some investments for their own accounts, even though that’s exactly what the Volcker Rule was intended to prohibit. The Dodd-Frank law (which again contained the Volcker language) tries to limit this behavior to activities related to “reasonably expected near term demands of clients, customers, and counterparties” – but this language is so vague that it’s practically meaningless.
The Volcker Rule also allows banks to engage in risk-mitigating hedging activities. But purchasing commodity futures to "hedge" against inflation risks might be nothing more than proprietary trading under another name. The crafters of the Volcker Rule even acknowledged that distinguishing between true hedges and covert proprietary trades will be particularly difficult for regulators.
Finally, the Volcker Rule allows financial firms to invest in hedge funds or private equity funds if these investments advance a "public welfare" purpose. This section is ripe for abuse. What’s the burden of proof for arguing something is in the public welfare? Who is going to make those decisions? Are there enough regulators to weigh every case where a financial firm says it’s making an investment in the public interest?
The Volcker Rule had a simple purpose: stop banks from using the advantages they receive from implicit government backing to make risky investments. But Democrats and Republicans in Congress carved out so many exceptions based on their parochial interests that the provision is unworkable and ineffective. We should either have a true Volcker Rule, or get rid of it entirely. The current version won’t protect our economy from risky banking practices or stop proprietary trading; it will only add more layers of largely ineffective government bureaucracy and regulation.
David Meyers is a New York-based political commentator, lecturer, and consultant. From 2006 to 2009, David worked in the White House, and was later a speechwriter in the United States Senate.