Examining the Impact of the Volcker Rule
by Simon Johnson, Peterson Institute for International Economics
Testimony submitted to the House Financial Services Committee, the Joint Capital Markets and Government Sponsored Enterprises, and the Financial Institutions and Consumer Credit Subcommittee Hearing on "Examining the Impact of the Volcker Rule on Markets, Businesses, Investors, and Job Creation."
January 18, 2012
Note: This testimony draws on joint work with James Kwak, particularly 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown and White House Burning: The Founding Fathers, Our National Debt, and Why It Matters To You (forthcoming April 2012), and Peter Boone, including Europe on the Brink. [pdf]
A. General Points
B. Specific Concerns Expressed By Banks
First, bankers express concern that the Volcker Rule would discriminate against "safe" foreign sovereign debt. But if a bank is holding sovereign debt as a classic long-term banking investment, then this is in the "banking book" and hence not prohibited under the rule. Similarly, if a bank is underwriting or market making for sovereign debt, then this is also a permitted activity. The only restriction in question is whether a US banking entity can purely "prop trade" sovereign debt, i.e., buying and selling (or engaging in derivative transactions) for the purpose of short-term capital gain.
Proprietary trading in foreign sovereign debt is inherently risky. This is exactly the kind of gambling that led to the recent demise of MF Global. Just because someone claims that the debt of a foreign government is safe does not mean that is true. In fact, financial history is full of examples in which investment bankers (including those based in the United States) miscalculate or make exaggerated claims regarding sovereign risks. This point is only reaffirmed by recent experience in Western Europe, for example in Greece and Italy.
US government debt is treated differently under the rule—and this is appropriate. Trading in US government securities was principally included as a permitted activity because treasuries are the major instrument used by banks as collateral for a range of transactions and for asset-liability management. No further statutory extension or definition of permitted activity for Treasuries is needed—and the same holds for municipal debt. Underwriting and market making are already permitted, and classic "banking book" holdings are also permitted for US government debt.
Second, there is concern that the Volcker Rule would hurt liquidity and capital markets. In this regard, some attention is being paid to a report by Oliver Wyman, The Volcker Rule: Implications for the US corporate bond market, commissioned by the Securities Industry and Financial Markets Association (SIFMA).4
The current chair of SIFMA is Jerry del Missier, a top executive at Barclays Capital.5 The board also includes executives from Morgan Stanley, Societe General, UBS, BNP Paribas, HSBC, Deutsche Bank, Goldman Sachs, Citigroup, RBS, JP Morgan Chase, Credit Suisse, RBC, and Merrill Lynch. All of these companies would be affected by the Volcker Rule (according to the Oliver Wyman report, page 11).
The Volcker Rule is designed to remove subsidies from large banks that also operate proprietary trading at any significant scale. We should expect executives from these firms to oppose removal of these subsidies. To the extent that such subsidies may be expected to benefit shareholders, it can be argued that these executives also have a fiduciary responsibility to do all they can to ensure the subsidies continue (i.e., that the effectiveness of the Volcker Rule be undermined).
SIFMA's statement of its mission is clear: "On behalf of our members, SIFMA is engaged in conversations throughout the country and across international borders with legislators, regulators, media, and industry participants."6 There is nothing in their public materials to suggest the research they sponsor is designed to uncover true social costs and benefits; rather their goal is to advance the interests of their members—this is a lobby group. SIFMA claims to represent the entire securities industry but more than one-third of its board is drawn from very large banks that would find their implicit subsidies cut and constrained by an effective Volcker Rule. Given this context, it is not clear why the Olivier Wyman study would be regarded as anything other than a form of special interest lobbying.
There is also a serious methodological issue. The Oliver Wyman study draws heavily on a paper by Jens Dick-Nielson, Peter Feldhutter, and David Lando, which looks at the liquidity premia for corporate debt.7 The Olivier Wyman study claims that the Volcker Rule will make corporate bonds less liquid and therefore increase interest rates on such securities, but their approach assumes the answer—which is not generally an appealing way to conduct research.
Specifically, the Oliver Wyman study assumes that every dollar disallowed in pure proprietary trading by banks will necessarily disappear. But if money can still be made (without subsidies), the same trading should continue in another form. For example, the bank could spin off the trading activity and associated capital at a fair market price. Alternatively, the trader—with valuable skills and experience—will raise outside capital and continue doing an equivalent version of his or her job.
If there is money to be made absent "too big to fail" subsidies, then an efficient capital market would suggest that the traders and the associated capital will remain engaged in some form. Now, however, these traders will bear more of their own downside risks. If it turns out that the previous form or extent of trading only existed because of the implicit government subsidies, then we should not mourn its end.
The Oliver Wyman study further assumes that the impact of the Volcker Rule will be similar to the financial crisis, and then seeks to measure that. This is ironic, given that the financial crisis severely disrupted liquidity and credit availability more generally—in fact this is the point of the Dick-Nelson, Feldhutter, and Lando paper.
The Volcker Rule may actually support more liquid markets by ensuring that the banks focus on providing liquidity as market makers—rather than draining liquidity from the market in the course of "trading to beat" institutional buyers like pension funds, university endowments, and mutual funds.
More generally, Thomas Philippon finds limited or no social benefits from increased trading activities per se.8 And the biggest disaster for the corporate bond market in recent years was a direct result of excessive risk taking by big financial players.
C. The Proposed Rule
On the positive side, the proposed Volcker Rule would collect data, enabling regulators to know more about what firms are doing. It sensibly restricts proprietary trading—including by prohibiting traders from being compensated for making proprietary-type bets. There are also restrictions on investments in private funds of various kinds.
However, there is also definite room for improvement. There are currently insufficiently clear lines on what is permitted; this makes it hard for regulators to enforce and for industry to comply. Much clearer presumptions could be provided—much as the industry does today on some trading desks.
More broadly, under the proposed rule, firms would be allowed to set their own rules and compliance policies. This is a recipe for inconsistency between firms and loose regulation. If the banks are allowed to create large enough loopholes, the rule will not be effective and big banks will again be able to use proprietary trading to gamble excessively—with their losses ultimately being borne by the American taxpayer.
1. See http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf [pdf] and the proposed rule at http://fdic.gov/news/board/2011Octno6.pdf. [pdf]
2. To measure just the fiscal impact of the finance-induced recession, compare changes in the CBO's baseline projections over time. In January 2008, the CBO projected that total government debt in private hands—the best measure of what the government owes—would fall to $5.1 trillion by 2018 (23 percent of GDP). As of January 2010, the CBO projected that over the next eight years, debt would rise to $13.7 trillion (over 65 percent of GDP)—a difference of $8.6 trillion. Of the change in CBO baseline, 57 percent is due to decreased tax revenues resulting from the financial crisis and recession; 17 percent is due to increases in discretionary spending, some of it the stimulus package necessitated by the financial crisis (and because the "automatic stabilizers" in the United States are relatively weak); and another 14 percent is due to increased interest payments on the debt—because we now have more debt.
3. There is nothing in the Basel III accord on capital requirements that should be considered encouraging. Independent analysts have established beyond a reasonable doubt that substantially increasing the required equity funding for large banks (i.e., their capital) would not be costly from a social point of view (e.g., see the work of Anat Admati of Stanford University and her colleagues).
4. The report is available on the SIFMA webpage that contains its comment letters to regulators. On page 36 of the report, the disclaimer begins, "This report sets forth the information required by the terms of Oliver Wyman's engagement by SIFMA and is prepared in the form expressly required thereby." The precise terms of this engagement are not stated in the document.
5. Available at http://www.sifma.org/about/board-and-officers/.
6. Available at http://www.sifma.org/about/join-sifma/.
7. This paper [pdf] shows "Illiquidity premia in US corporate bonds were large during the subprime crisis. Bonds become less liquid when financial distress hits a lead underwriter."
8. Thomas Philippon, "Has the US Finance Industry Become Less Efficient?" [pdf]