No Gambling With Federal Funds

Back in January, when President Barack Obama first signaled that thorough-going financial reform would be a top priority in 2009, he declared that the Volcker Rule should be included in any financial regulatory reform package passed on Capitol Hill. The rule, named after former Federal Reserve Chairman and current administration adviser Paul Volcker, is aimed at reining in some of the risky trading practices by some the nation’s biggest financial institutions—practices that contributed to the economic crisis of 2008.

At its core, the Volcker Rule is meant to prevent the nation’s biggest banks from engaging in proprietary trading, or trading for their own benefit, divorced from that of their customers, with federally insured funds. It prohibits proprietary trading at any insured depository institution or financial firm that is treated as a bank holding company. And it also bans those same institutions from sponsoring or investing in hedge funds or private equity firms.

The aim is tamping down on risk at the largest, most interconnected, “too big to fail” financial institutions by keeping them from making risky bets while simultaneously benefiting from a federal backstop provided by the Federal Reserve or the Federal Deposit Insurance Corporation. Because they have access to Federal Reserve funds, bank holding companies can currently engage in proprietary trading with cheap federal money. Depository institutions, meanwhile, are covered by FDIC insurance to ensure that depositors don’t get wiped out if the firm goes under.

During the 2008 financial crisis, both bank holding companies and the investment banking arms of depository institutions gambled and lost on the mortgage-backed securities marketplace they helped build to bubble proportions and then received a government rescue because they were systemically risky and entangled with the rest of the financial system. Going forward, the Volcker Rule will protect taxpayers from providing a cushion for this sort of gambling in financial markets.

Not surprisingly, the measure has met with stiff resistance from the banking industry, which is bent on either blocking the Volcker Rule entirely or watering it down to such an extent that it is rendered meaningless. It also initially elicited skepticism from members of Congress. Nonetheless, the financial reform bill passed by the Senate Banking Committee earlier this month includes a version of the Volcker Rule, albeit with more leeway for regulators to implement it than originally proposed by the administration.

The banking industry argues that the Volcker Rule is unnecessary, claiming that proprietary trading did not play a role in the economic meltdown. As JP Morgan Chase’s Chief Risk Officer Barry Zubrow told the Banking Committee, “there may be valid reasons to examine these activities, [but] there should be no misunderstanding: the activities the administration proposes to restrict did not cause the financial crisis.”

Many factors, of course, directly caused the simultaneous U.S. housing crisis and global financial crises, including direct proprietary trading in the mortgage-backed securities that were at the heart of both. Zubrow significantly downplays the extent to which proprietary trading incentivized risk taking and threw jet fuel on the subprime lending fire.

As the Center for Public Integrity points out, many of the most prolific subprime lenders were heavily backed by Wall Street firms, which were bundling the loans, turning them around, and selling them to investors, driving demand that pushed lending standards increasingly lower. These same firms also made markets in these securities to keep the subprime lending boom rolling and some then bet against the securities in the secondary market as the housing crisis began to hit in late 2007. "Proprietary trading played a big role in manufacturing the CDOs and other instruments that were at the heart of the financial crisis," explains Michael Madden, a managing director of the investment firm BlackEagle Partners and a former Lehman Brothers executive. "If firms weren’t able to buy up the parts of these deals that wouldn’t sell…the game would have stopped a lot sooner."

This view is seconded by the Political Economy Research Institute at the University of Massachusetts, which said that “risky proprietary investments by investment banks, along with trading for clients whose decisions were influenced by these banks, was one of the main forces that sustained upward pressure on security prices in the bubble.”

A second argument that the banks resort to is to insist that a ban on proprietary trading will inhibit their ability to make markets (in which they both sell to and buy from their customers), which is essential for them to ultimately serve their customers’ interests. Goldman Sachs CEO Lloyd Blankfein made this claim during testimony before the Financial Crisis Inquiry Commission to justify Goldman making trades directly opposed to its clients’ positions.

But as it’s designed, the Volcker Rule should not prevent the trading desks of large financial institutions from making markets—so long as they’re doing it on behalf of their clients. In fact, the rule explicitly states that market-making activities are necessary and not subject to the ban. What the rule will do is prevent these financial institutions from running an entirely separate proprietary trading desk, divorced from their customers’ interests.

The banks also argue that, if they are unable to engage in proprietary trading, such trading will migrate to lighter regulated parts of the financial system, such as hedge funds and private equity firms. This is likely true. But it’s also an acceptable outcome. If such trading is going to occur, it should occur within financial firms that do not benefit from government insurance, and thus can fail if risky trading results in catastrophic losses. It will be important going forward to ensure that other parts of the financial system aren’t allowed to grow and become entangled to such an extent that they become a systemic risk, but that’s not an argument against reining proprietary trading by the biggest financial institutions.

Worried that these common-sense rebuttals to their arguments will carry the day in Congress, bankers are also working hard to weaken the proposed law, including pushing for regulators to be given wide discretion to implement it. For instance, while the administration’s original proposal included complete legislative language detailing how the Volcker Rule would work in practice, in order to garner wider support, the Banking Committee’s legislation says regulators will study how to best design the rule and then “shall” implement it in the way that makes the most sense.

But this isn’t enough to appease the bankers, who want this “shall” to be converted into a “may,” explicitly giving regulators, not lawmakers, the final say over whether the rule exists at all. And prior to markup of Sen. Christopher Dodd’s (D-CT) bill in the Senate Banking Committee, Sen. Richard Shelby (R-AL) introduced an amendment doing just that, swapping the “shall” for “may.” (Shelby ultimately decided to withdraw the amendment, as Republicans decided en masse to bring up their changes on the Senate floor instead of in committee.)

Allowing regulators this much discretion could lead to a weak and ill-enforced rule. The banks can and will put intense pressure on the regulators to bend or ignore it, just as they did in other ways in the buildup to the last crisis. As Volcker himself said, “In my opinion, it’s very unlikely that the regulators and supervisors would evoke a strict prohibition until a crisis came and then it’s too late. Look, I’ve been a regulator for 20 years. So I know how they are.”

It’s not only the administration and Sen. Dodd who would like to see the Volcker Rule implemented in some form. Five former treasury secretaries penned a letter to The Wall Street Journal saying that the Volcker Rule is “a key element in protecting our financial system and will assure that banks will give priority to their essential lending and depository responsibilities.” Former Citigroup CEO Jack Reed (who was instrumental in tearing down the barriers between investment and commercial banking in the 1990s) has added that “the industry should be compartmentalized so as to limit the propagation of failures and also to preserve cultural boundaries.” And Kansas City Federal Reserve President Thomas Hoenig also offered his support for the rule last week, saying that it would be “healthy for long-term stability.”

Financial regulatory reform should be aimed at not only addressing the regulatory gaps and deficiencies that led to the 2008 financial crisis, but also at ensuring that the financial system is stable and secure in the future, with no one entity able to hold the entirety hostage. While proprietary trading was not the sole contributor to the financial crisis, it played its part in creating a risk structure that was bound to blow up. The Volcker Rule is an integral part of ensuring that this doesn’t happen again.

Pat Garofalo is an Economics Researcher at the Center for American Progress and a Blogger at the Center for American Progress Action Fund.