Stopping The Next Crisis Before It Starts?

Yesterday, regulators finalized the Volcker rule, which is intended to prevent banks from engaging in certain types of risky behavior. Neil Irwin explains the rule:

It is part of the Dodd-Frank financial reform act that passed in 2010 that aims to prevent giant banks from engaging in speculative trading activity. The idea is that, while it is important for banks to support the economy by lending to consumers and businesses, when they get into the realm of making bets in exotic financial markets — known as proprietary trading — they aren’t really doing anything to support the economy. But trading for their own accounts does risk their own solvency in ways that could lead them to fail and necessitate a costly government bailout. In short, the theory is: You can speculate on financial markets. Or you can have a government safety net. But you can’t have both. …

The rule isn’t enough to prevent any future crisis, certainly. Banks have shown plenty of ability to get into trouble with strategies that have nothing to do with proprietary trading. For example, nothing about these rules would stop a bank from making crummy mortgage loans. But it is certainly plausible that this will choke off one route by which the biggest banks could come into danger of triggering another financial crisis.

Matt Levine weighs in:

The Volcker rule was supposed to shut down proprietary trading desks, and it basically already has. The Volcker rule was not supposed to shut down market making and hedging, which are risky and proprietary and complicated and all that good stuff, but which are also both economically important and specifically allowed by Congress. That’s a simple sentence to write, but a hard thing to make happen. The final rule is 978 pages long, but it’s not a bad effort at achieving that simple result.

Mike Konczal defends the rule:

The problem there is that lending to households and businesses is the core function of banking. And there are good reasons why banks provide this service instead of other types of firms. For instance, funding increases as relationships between firms and creditors evolve (for more, see Fama 1985 or Petersen and Rajan 1994). So other firms can’t easily do what banks do when it comes to lending. But other firms can definitely engage in proprietary trading—including hedge funds, mutual funds, sovereign wealth funds and others. So if proprietary trading does have any benefits to society at large, there’s nothing to worry about. It will still take place. On the other hand, if banks are prohibited from lending, it’s not clear that other institutions could pick up the slack.

Simon Johnson is withholding judgment:

The Volcker Rule could be a major contribution to financial stability. Or it could still flop. The devil now is in the details of implementation and compliance – and how much of this becomes public information and with what time lag.

David Dayen also looks at implementation:

“The truth is that this is kind of the end of the beginning,” said Marcus Stanley of Americans for Financial Reform. The regulators must now set out guidelines for market-making, hedging and other bank activities, collecting data and developing more specific parameters for what gets prohibited. And they agreed to delay actual enforcement of the rule until July 2015. This gives banks time to open more loopholes, adjust to the requirements and ready lawsuits. Already, loopholes have been uncovered allowing banks to trade foreign sovereign debt and invest in small hedge funds, which could result in risky trading merely shifting to other areas rather than being stamped out.

Stanley worries that, as the fight shifts to implementation, regulators could shield the data from public view, designating it “confidential supervisory information.” That means we may not really know whether or not the Volcker rule is working.

Jonathan Weil expects the rule to have little effect:

[T]here’s some merit to having a ban: Lots of people dislike the idea of banks gambling with federally insured customer deposits, because they might blow themselves up and either cause damage to others or require a taxpayer bailout. But once you get into the weeds, there’s always a workaround or a nasty, unintended consequence of one sort or another. Old-fashioned lending often may be riskier than betting it on prop trades anyway. It could take years before regulators figure out the full effects of all the wonderful little loopholes that well-paid bank lobbyists worked into the language. Even if the rules were flawlessly written — and they never are — there is the matter of whether they will be enforced consistently, which they tend not to be from one administration to the next.

Yglesias bets that the rule will be weakened over time:

The way the regulatory state works is that first congress writes a law, then regulators write a detailed rule, and then people who think the rule is unfair to them get to sue and get judges to throw the rule out. If you’re some kind of bank regulation junky who thinks the rule is too kind to banks, you do not get to sue and get judges to make the rule stricter. This is one of a dozen of reasons why “judicial nominations” matter for more reasons than “the Supreme Court rules on abortion rights.” There’s an ongoing fight in Congress about appointees to the D.C. Circuit Court which is rich in regulatory implications, of which the Volcker Rule battle is one.

And Stephen Mihm notes that it could take a long time to see whether the rule is working:

And therein lies a lesson about post-crisis regulation. In the chaos of a financial crisis, never mind its aftermath, it’s easy to jump the gun and impose regulations that satisfy the urge to “do something” yet achieve little to address the underlying causes of the disaster. The resulting regulation can deliver benefits, or it can be counterproductive. Or both. But neither outcome is dependent on a correct reading of the causes of the crisis. This will probably be true of the Volcker rule, too: It will be judged not on whether it was a logical response to what happened, but whether it ushers in a new era of financial stability. On that question, we may have to wait years for a clear answer.