Forget Volcker — bring back Glass-Steagall
Imagine you are a financial regulator whose agency is underfunded, understaffed and under-trained and that firms under your jurisdiction are likely to pick off your best employees by offering them triple the salary you pay them.
Furthermore, imagine that Congress has written an 800-page law that instructs you to write and enforce new regulations on banks and securities firms to ensure financial stability for the system. The most complex part of this new law, the Volcker Rule, would require you to cooperate with three other agencies to jointly issue a 530-page Proposed Rule that asks 1,300 questions.
Now imagine that in the course of honing this rule, 17,000 comment letters will flow into your agency, the majority of which promote the status quo.
After going through this thought experiment, you’d probably say: “What a headache! Why can’t we just bring back Glass-Steagall and split up banks into risky trading machines and safe depository institutions? This monstrosity of a regulatory fiat will never be properly defined or adequately enforced.”
The Volcker Rule is supposed to isolate the risk of a bank trading its own assets and separate that from depositors’ assets. In other words, the Volcker Rule should isolate the risk of a big derivatives or fixed-income loss on the house account from the cash savings of retired teachers and other customers of the bank. By design, it is aimed at the heart of the nation’s largest banks, the five institutions that use their enormous staffs and FDIC-insured balance sheets to dominate trading and commercial banking.
Take JPMorgan Chase, for instance. Tuesday it released the employee headcount of its investment bank: 2,500 salespeople and 2,000 traders on 110 trading desks in 20 trading centers, in addition to its 2,000 investment bankers. JPMorgan trades securities in 12 asset classes using its risk-weighted assets of $467 billion. Although JPMorgan and other banks are less leveraged than they were prior to the financial crisis, they are still pumped up trading engines attached to slow-moving, deposit-taking banks. In the derivative space alone JP Morgan’s total credit exposure was 285 percent of its risk-based capital in Q3 2011, according to the Office of the Comptroller of the Currency (graph 5A).
The core issue in attempting to define the Volcker Rule is that federal securities and banking regulators have never really supervised the fixed-income and derivatives markets. Dodd-Frank has many provisions for the regulation of derivatives but entirely skips over any requirement to regulate bond trading. The SEC heavily regulates stock trading but conducts little to no oversight of bond markets. Bonds are an enormous, dark market that few people understand, hence all the laments that eliminating prop trading of bonds will dry up liquidity — a ridiculous idea. If there are larger profits in bond trading because the five major banks are limited, new entrants will expand into the market to capture those profits and provide liquidity.
Now if bond trading had historically been regulated, it’s likely that regulators would have the experience to easily identify trades done for the house account (proprietary trading ) and those done for clients. Federal Reserve Chairman Ben Bernanke said yesterday in a House Financial Services Committee hearing (via Bloomberg):
Bernanke said the “most difficult distinction” in the rule is the difference between proprietary trading and market making. “We will need to develop metrics and other criteria to distinguish those two types of activities,” Bernanke said.
That is equivalent to throwing an inexperienced sailor aboard an ocean liner and asking him to figure out how to separate the systems that power the ship’s light from those that power the engines. Good luck with that. It’s doubtful that regulators can manage that kind of complexity with no prior experience.
When Congress passed the Gramm-Leach-Bliley Act (GLBA) in November 1999, it effectively repealed the long-standing prohibitions on mixing banking with securities or insurance businesses, sounding the death knell of Glass-Steagall. In 2000 researchers at the OCC wrote a paper that said:
GLBA generally adheres to the principle of “functional regulation,” which holds that similar activities should be regulated by the same regulator. How regulators will in practice coordinate their efforts so that the safety and soundness of the banking system is maintained efficiently remains to be seen.
So Glass-Steagall was killed, and no one regulated the two largest areas of the financial markets, fixed income and derivatives. I’m afraid that Chairman Bernanke and his regulator colleagues will never be able to ensure the stability of the financial system long term with the Volcker Rule. Let’s make life simple for everyone and bring back Glass-Steagall.
Reuters: Analysis: High hurdle for Volcker rule foreign debt exemption