How to Really Rein in the Banks

The so-called Volcker rule isn't the best way to keep banks from going wild with risk.

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Federal financial regulators are getting set to vote on the long-awaited Volcker rule, a key part of the Dodd-Frank financial reform law that aims to prohibit banks relying on deposit insurance from engaging in risky trading activities. In the words of the provision's authors, it reflects the view "that high-risk, conflict-ridden trading should not be subsidized by taxpayer insured deposits and cheap credit from the Federal Reserve."

That laudable goal must be assessed in light of the provision's unintended consequences and its administrative complexities. Policymakers have other options that could address the issue of taxpayer-subsidized risk-taking more effectively than the Volcker rule will.

Lawmakers included the Volcker rule in Dodd-Frank based on rhetoric rather than careful deliberation. Proprietary trades were not a significant cause of the financial crisis. More importantly, it is not clear that prohibiting firms from trading will make them safer. Although the research on this point is mixed, the diversification that trading provides might make banks safer than if they concentrate only on taking deposits and making loans.

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It is clear that banks can make themselves safer by entering into transactions to hedge the risks they take in their core customer-serving businesses. The Volcker rule makes it much more difficult for banks to do this, and the way regulators are interpreting it may make hedging even more difficult. Based on a recent Wall Street Journal article, the final rule may require that hedges be tied to "specific risks, such as interest-rate, currency or foreign-exchange risk." Banks often instead use portfolio hedging, which means that they do not individually hedge specific customer transactions, but protect themselves from broader risk exposures. If the Volcker rule limits their ability to do this, it will make hedging more expensive and difficult for banks, which could undermine their safety.

Raising the price of hedging also raises the cost of making markets — meaning standing ready to buy and sell securities. Market makers provide the liquidity that allows the rest of us to know that we will be able to buy and sell stocks and bonds whenever we want to do so. Market making is permitted under the Volcker rule, but the exemption is so cluttered with unclear conditions that banks may be scared to rely on it.

Complying with the Volcker rule and its hedging and market making exemptions may be even more expensive — and dangerous — than anticipated when the rule was proposed. As the Wall Street Journal reports, the final rule could include a requirement that CEOs certify their banks' compliance with the rule. By doing so, CEOs will be exposing themselves to the real risk — given how vague the lines are — that a regulator will later decide that trades that were undertaken for market making or hedging purposes actually ran afoul of the rule's nebulous conditions.

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Banks won't have to worry about regulators second-guessing trades in U.S. Treasury securities, which Congress exempted. Needless to say, the special treatment for U.S. government debt was highlighted by other government and private company issuers in their letters expressing concern about what the Volcker rule will do to markets in their securities.

Given the risks to banks and global markets that the Volcker rule carries with it, we ought to try to find a better way to achieve its worthy objectives. Any alternative solution would need to be rooted in private market discipline, rather than in the complicated regulatory oversight on which the Volcker rule relies. One such approach would be to address the core source of banks' dependence on taxpayers — deposit insurance — by limiting it to $50,000 per account, the amount it would have been had we simply allowed it to track inflation since its inception in 1934.

Our deposit insurance scheme, which at $250,000 per account is overly generous by international standards, has encouraged risk-taking by banks. Lowering the deposit insurance cap would still protect most banking customers (since the median American family does not even have $25,000 in the bank), and at the same time encourage large depositors to keep an eye on their bank. Enhanced transparency of bank portfolios would aid depositor monitoring. Other reform options include schemes to make shareholders and creditors absorb losses when a bank runs into trouble. These and other proposals outlined in a Mercatus Center publication, "Rethinking the Volcker Rule," would force banks, shareholders, and creditors to more carefully consider how much risky activity they can bear and to impose accordingly appropriate constraints on bank activities. The Volcker rule takes the less direct and more destabilizing approach of having the government micro-manage banks' trading.

Hester Peirce is a senior research fellow with the Mercatus Center at George Mason University. She previously served as counsel on the Senate Banking Committee during the drafting of the Dodd-Frank Act.

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