Volcker and the liquidity canard

February 14, 2012

Tom Keene of Bloomberg did a fantastic interview with legendary municipal bond broker James Lebenthal last week. It’s worth a listen, but a big, unanswered question from their discussion was how the municipal bond market could become more liquid for retail investors. It was rather surprising to hear Lebenthal stumped for an answer, since Wall Street’s largest banks have been whining that if the proposed Volcker Rule were implemented, it would kill the market liquidity they provide. The rule is still being fine-tuned by federal agencies, but at its core it will ban speculative securities trading by commercial banks. However, the Volcker Rule will allow commercial banks to continue the traditional securities activities of market making and underwriting fixed income.

Jim Lebenthal and Paul Volcker are the grand old warhorses of the U.S. financial system. They have worked in and overseen banks and securities dealers for decades. They also both worked for most of their careers under Glass-Steagall, the federal banking law that separated commercial banking and securities operations, until it was repealed in 1999. Both men have implied in letters and interviews that the current structure of the market is not optimal. The Volcker Rule is a partial return to the days of Glass-Steagall.

As Volcker points out in his comment letter to the federal agencies that will implement his eponymous rule, the “liquidity” that banks claim their speculative trading adds to markets is not an essential part of financial services:

The basic public policy set out by the Dodd-Frank legislation is clear: the continuing explicit and implicit support by the Federal government of commercial banking organizations can be justified only to the extent those institutions provide essential financial services. A stable and efficient payments mechanism, a safe depository for liquid assets, and the provision of credit to individuals, governments and business (particularly small and medium-sized businesses) clearly fall within that range of necessary services.

Proprietary trading of financial instruments – essentially speculative in nature – engaged in primarily for the benefit of limited groups of highly paid employees and of stockholders does not justify the taxpayer subsidy implicit in routine access to Federal Reserve credit, deposit insurance or emergency support.

Volcker argues that “only six banks account for almost 93 percent of the trading revenue of all American banks.” Furthermore, he asks, is excessive “liquidity” even beneficial for the economy? Again from his comment letter (page 3):

As a general matter, efficient markets do need arrangements to facilitate trading in financial instruments. That ability to buy and sell large volumes of assets on short notice (termed “liquidity”) appeared, prior to the crisis, to be greatly enhanced. There should not, however, be a presumption that evermore market liquidity brings a public benefit.

At some point, great liquidity, or the perception of it, may itself encourage more speculative trading, even in longer-term instruments. Presumably conservative institutional investors are tempted to turn over positions much more rapidly, at the expense of careful analysis of basic values.

In the light of events, careful consideration of the benefits and possibly damaging consequences of increased liquidity has become the subject of new studies and commentary by economists and regulators. A consensus may be developing that beyond some point, little or no public benefit may be evident.

In any event, the restrictions on proprietary trading by commercial banks legislated by the Dodd-Frank Act are not at all likely to have an effect on liquidity inconsistent with the public interest.

A small number of enormous banks dominate financial markets. These banks have commercial banking licenses and therefore the implicit guarantee of a federal backstop in case of failure. They also have concentrated fixed income and derivative trading into the control of a few hands. The proprietary trading of the megabanks was a factor in the near collapse of the global financial system in 2008. Taking away some of the megabanks’ ability to dominate fixed income through their federally backstopped balance sheets will give other participants more opportunity to trade in these markets. This will help the markets look more like the ones the old warhorses remember, where firms failed and new ones took their place. This is true liquidity.


If you have not seen the comment letter submitted by “Occupy the SEC” regarding the Volcker Rule, it’s definitely worth a look. I’d say it is as well or better written than the comments submitted by any organization.

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