The Volcker rule’s loopholes

By Felix Salmon
February 3, 2010
Paul Volcker's long NYT op-ed last weekend, and his testimony to the Senate banking committee this week, did very little to clear up a lot of the uncertainty over what exactly the Volcker rule comprises. That was probably deliberate, given the degree to which Chris Dodd is skeptical that any such rule can be implemented at all. But the contours of a Volcker rule are slowly emerging all the same, and that they carve out two enormous loopholes.

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Paul Volcker’s long NYT op-ed last weekend, and his testimony to the Senate banking committee this week, did very little to clear up a lot of the uncertainty over what exactly the Volcker rule comprises. That was probably deliberate, given the degree to which Chris Dodd is skeptical that any such rule can be implemented at all. But the contours of a Volcker rule are slowly emerging all the same, and that they carve out two enormous loopholes.

Firstly, the Volcker rule seems to apply only to depositary institutions: if you don’t take deposits, then you’re exempt. The result is that it’ll be easy for Goldman Sachs and Morgan Stanley to get around the rule just by returning their current (tiny) deposit base and voluntarily withdrawing from access to the Fed’s discount window.

But the point here is that banks with deposit bases are already insured and regulated, by the FDIC. The definition of a bank isn’t an entity which takes deposits; it’s an entity which borrows short and lends long. So long as the likes of Goldman Sachs can fund themselves in the wholesale market and continue to lend money to large clients in things like the syndicated loan market, they’re banks, and they should be subject to rules like Volcker’s which apply to banks.

Secondly, it seems that banks might be allowed to continue to own hedge funds, private-equity funds, money-market funds, and the like, just so long as they’re run for clients, with client money, rather than being vehicles for the investment of the bank’s own capital.

This too is dangerous, because the history of the financial crisis is clear: Bear Stearns ended up bailing out its internal hedge funds even when it didn’t legally have to. Large banks ended up bailing out clients who invested in auction-rate securities. Fund managers ended up putting up their own capital to stop money market funds from breaking the buck. Banks with SIVs ended up bringing them onto their own balance sheet, taking enormous associated losses. Etc etc. Essentially, a bank might say that it has no exposure to such things, and that all the risk lies with its investing clients. But that’s never, ever true.

So while I think that the Volcker rule is a good idea, I also think that it has already been diluted to a point at which it will do very little good. If prop trading is a problem, it’s much more of a problem at Goldman Sachs than it is at Wells Fargo — yet the Volcker rule would apply to Wells Fargo and not to Goldman Sachs. Similarly, if owning hedge funds is a problem, it’s a problem whether or not the bank’s capital is nominally invested in the fund, but the Volcker rule gives banks an easy way to wriggle out from under it, simply by withdrawing their own investment.

So my feeling is that the Volcker rule probably won’t make its way into law, and that it’ll be largely toothless if it does. A shame.

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