Volcker’s rule on rules
Former Fed chairman Paul Volcker has some advice for financial regulators writing rules to define new limits on banks’ ability to trade for their own accounts: be as vague as possible. At least that’s the message in this WSJ piece by Deborah Solomon (for which, to be upfront, Volcker declined to comment).
At first pass, that sounds a little nuts. If Dodd-Frank means to clamp down on proprietary trading at institutions that receive federal guarantees (like deposit insurance), then why wouldn’t regulations spell out, as specifically as possible, what those banks aren’t allowed to do? Solomon explains:
Mr. Volcker’s concern, according to several people familiar with the matter, is that narrow or prescriptive rules would invite gamesmanship on the part of banks and could allow firms to evade the rule’s intent. Already, some banks and their lobbyists are seeking to sway regulators and encourage them to narrowly define certain types of trading activities, according to government officials.
By being less specific, the logic goes, regulators will better be able to adapt to changing circumstances—and to banks’ tactics. Solomon compares this approach to the one the government already employs in the realm of money laundering. Another good example is insider trading law. It’s never been particularly clear what is, and what isn’t, insider trading. This can lead to bumpy prosecutions, but it does serve the important purpose of preserving flexibility. Leaving a fair amount of case-by-case judgment in the system lets regulators tap what Michael Polanyi called “tacit knowledge,” or the thing Supreme Court Justice Potter Stewart was getting at when he wrote of pornography: “”I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it.”
In this Bloomberg column, Michael Lewis gives us reason to think this might be a good way to go. He writes:
The banks have no intention of ceasing their prop trading. They are merely disguising the activity, by giving it some other name. A former employee of JPMorgan, for instance, wrote to say that the unit he recently worked for, called the Chief Investment Office, advertised itself largely as a hedging operation but was in fact making massive bets with JPMorgan’s capital. And it would of course continue to do so. JPMorgan didn’t respond to a request for comment.
One conclusion: to have the best chance of ferreting out prop trading, regulators are going to need a lot of leeway in deciding what they go after.
Interestingly, though, Lewis comes to a different conclusion. He doesn’t opt for vague rules, but rather very strict, draconian ones that would change the face of finance more dramatically than most people probably imagine Dodd-Frank doing:
There’s a simple, straightforward way… to construe the Dodd-Frank language, and it would reform Wall Street in a single stroke: to ban any sort of position-taking at the giant publicly owned banks… If that means that Goldman Sachs is no longer allowed to make markets in corporate bonds, so be it. You can be Charles Schwab, and advise investors; or you can be Citadel, and run trading positions. But if you are Citadel you will be privately owned. And if you blow up your firm, you will blow up yourself in the bargain.
If you have little faith in regulators’ ability to keep up with Wall Street innovation* behavior and to use flexible rules to their fullest, then maybe Lewis’s approach is the smarter one. I’m sympathetic to that argument; I’ve voted to chop up overly large and entwined financial institutions before. But I don’t know if at this point that path is politically feasible. Dodd-Frank could have broken up the banks, but it didn’t. And I’m not sure that since the bill passed, the political clout of the be-tough-on-Wall-Street camp has grown.
Yet that camp is, admirably, still fighting. A group of senators, led by Carl Levin, recently wrote a letter to the new Financial Stability Oversight Council, urging regulators to really crack down and not let Dodd-Frank get watered down in the rule-making. It’s a good thing for people to hear, but so is Volcker’s message—that often the toughest rules are the ones that specifically prohibit the least.
*I regret having used this word, so I have gone back and changed it.