The Volcker Rule and the Curse of the Second Best Solution (Part 1)

One of the key components to Dodd Frank was the so called Volcker Rule.  Sometimes characterized as a mini-Glass Steagall, this provision prohibited banks from engaging in short term proprietary trading or from operating hedge funds.  The Report issued by the Financial Stability Oversight Council in January 2011 about the requirement is here.  The final rule is here.

The Rule, consisting of hundreds of pages, has been criticized as excessively complex and full of potential loopholes.  Banks can still engage in certain hedging transactions, market making activities, transactions in government securities and transactions on behalf of clients. 

Putting aside the legitimate concerns over implementation of the Volcker Rule, the real problem is more central.  The Volcker Rule represents a second best solution to a problem that is well known but intractable.  The central problem is that the largest financial institutions, no matter what regulators and politicians say, are too big to fail.  

With the four largest commercial banks in the US each having consolidated assets of over $1 trillion, the failure of any one of them would have profound effects on the economy.  The economic catastrophe that followed in the collapse of the much smaller Lehman set off (or greatly contributed to) a damaging recession that may have altered the outcome of a presidential race.  Given that risk, no politician, Democrat or Republican, will likely allow that to happen under his or her watch.

The obvious solution would be to make the financial institutions smaller and allow them greater freedom to operate.  If they took excessive risk and failed, they would suffer the consequences.  Breaking up the commercial banks, however, is not a viable solution.  There is no will.  Nor is there agreement on the method of doing so nor the ultimate size of a bank that would not be too big to fail.

The second best solution then is to reduce the risk that one of these behemoths will fail.  One way to do that is to have government regulators camp out at the various banks and prevent excessive risk taking.  They already do that.  See Testimony of Thomas J. Curry, June 19, 2012 before the House Committee on Financial Services ("The primary focus of examiners is to determine whether banks have sound risk control processes commensurate with the nature of their risk-taking activities, capital, reserves, and liquidity. Given the millions of transactions that large banks conduct daily across varied product lines and businesses, examiners do not review every transaction in a bank."). 

Indeed, the FDIC maintains a permanent staff at some or all of these large financial institutions.  So does the Office of the Comptroller of the Currency.  See Testimony of Thomas J. Curry, June 19, 2012 before the House Committee on Financial Services ("The foundation of the OCC’s supervisory efforts is our continuous, onsite presence of examiners at each of the 19 largest banking companies.").  

The losses at JP Morgan forced on regulators a reexamination of their oversight role, see   Testimony of Thomas J. Curry, June 19, 2012 before the House Committee on Financial Services ("We are also undertaking a two-pronged review of our supervisory activities and response. . . . The second component evaluates the lessons learned from this episode that could enhance risk control and risk management processes at this and other banks and improve OCC supervisory approaches."), and may result in more effective oversight. 

Nonetheless, the potential for excessive risk taking cannot be eliminated by government oversight.   Developments happen quickly.  In some circumstances, they are brought about by a single person (remember the collapse of Barings?).  They may also be covered up by the perpetrators.   

As a result, the Volcker Rule gets at the concern over excessive risk taking in a blunderbuss way.  It simply bans certain kinds of transactions. Doing so will take away profit making opportunities for the banks.  It will not necessarily result in greater stability for the entire financial system since other, less regulated investors, may engage in the transactions previously undertaken by banks.  But what it will do is reduce the likelihood that a bank will take a bet in the capital markets that threatens its solvency and triggers the problem of too big to fail.

For an article on the consequences of repealing Glass Steagall, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.

J Robert Brown Jr.