How Levin’s crisis report recasts the Volcker Rule

By Felix Salmon
April 14, 2011

After the Financial Crisis Inquiry Commission fractured into bipartisan incommensurability, I had little hope for the Senate’s report into the financial collapse. But my initial impression is that it’s a great piece of work — almost incredibly so, given that it’s got bipartisan support.

The whole 5.9 MB, 650-page report can be found here, and there are another 5,800 pages of appended documents which can be found from the links at the bottom of this PDF press release. Given the enormous amount of work which went into collating and writing this report, I have to say I’m disappointed in the way in which it doesn’t even have its own web page — this material should all be online, easily indexable and searchable.

I’m going to take my time with this report. But to get a flavor of its tone, take a look at the list of recommendations which are summarized on pages 12-14 (or pages 20-22 of the PDF). They basically take the armature of Dodd-Frank and toughen it up substantially: Carl Levin and his colleagues clearly reckon that Dodd-Frank is a good start, rather than a response which is sufficient in and of itself.

I’m particularly taken with the way in which the report sees the Volcker Rule as an ethical issue, rather than as a moral-hazard issue. As I recall, the stated justification for the Volcker Rule was that it’s ridiculous for the Federal Reserve to give valuable access to its discount window to banks who can just take that money and gamble it on proprietary trades. If people want to gamble, that’s fine, but they shouldn’t do so with taxpayer dollars.

But Levin’s report puts the Volcker Rule in a different light. It quotes Jeremy Grantham:

Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs, for example, would never, ever have traded against its clients. How quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who suggested such behavior would have been fired as both unprincipled and a threat to the partners’ money.

It then goes on to say that “the Dodd-Frank Act contains two conflict of interest prohibitions to restore the ethical bar against investment banks and other financial institutions profiting at the expense of their clients”.

The Volcker Rule has yet to be nailed down, of course — and there are serious questions over whether it will ever be enforceable. But if it’s written in a principle-based way, then I think this is a very useful principle to include. Is an investment bank profiting at the expense of its clients? If so, it’s probably violating the Volcker Rule.

In the case of something like the Abacus transaction, of course, the answer is clearly yes. Goldman Sachs said over and over again that IKB, one of its clients in that transaction, was “sophisticated”, as though that in and of itself absolved Goldman of any responsibility to the German bank. But a conflict-centered Volcker Rule would not include carve-outs for sophisticated clients, and might well prevent such transactions in future.

Levin’s report says hopefully that just such a rule can be “well implemented”, and would “protect market participants from the self-dealing that contributed to the financial crisis”. I’m not convinced. But it’s certainly worth a try.

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