Forget Volcker — bring back Glass-Steagall

March 1, 2012

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


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“The SEC heavily regulates stock trading but conducts little to no oversight of bond markets.”

That’s simply not true. The bond businesses of banks and broker-dealers are heavily regulated. There are regulations related to suitability, capital, trade reporting, record keeping, testing and qualifications, pricing and markups, etc. And when FINRA or SEC examiners look at dealers, they look at their bond activities as closely as anything else. With regard to muni bonds, municipal bond dealers are the only segment of the capital markets that have their own, dedicated regulatory agency, the MSRB. FINRA and the SEC frequently announce enforcement actions against rule violators in the bond market. How can you say the market isn’t regulated?

“So Glass-Steagall was killed, and no one regulated the two largest areas of the financial markets, fixed income and derivatives.”

This is partly true for derivatives. It isn’t true at all for bonds. It’s true that before Dodd-Frank, over-the-counter derivatives weren’t regulated. But that had nothing to do with the GLBA. It was the Commodity Futures Modernization Act, not the GLBA, that specified that no federal regulator had authority over derivatives. And all that’s changed now, any way. A big part of Dodd-Frank is the new authority the CFTC and SEC have over swaps, swap dealers and major swap users.

Posted by DogFase | Report as abusive

Thanks for the comment DogFase.

Regulators do collect post trade data on bond trading and occasionally you hear of fines against brokers for excessive markups on a retail investor. The MSRB is currently undertaking rulemaking for broker’s broker Rule G-43 as described below. This is one of the few times that a regulator is imposing a rule pre-trade and I don’t believe that you can find a comparable rule for other bond types ie corporates, agencies, Treasuries or sovereign. If I have missed that rulemaking I’d appreciate you pointing it out.

MSRB Proposed Rule for G-43 tions/Regulatory-Notices/2011/ px?n=1

Under Revised Draft Rule G-43(d)(iii), the term “broker’s broker” would mean a dealer, or a separately operated and supervised division or unit of a dealer, that principally effects transactions for other dealers or that holds itself out as a broker’s broker, whether a separate company or part of a larger company.

The role of the broker’s broker is that of intermediary between selling dealers and bidding dealers. Revised Draft Rule G-43(a) would set forth the basic duties of a broker’s broker to such dealers.[2] Revised Draft Rule G-43(a)(i) would incorporate the same basic duty currently found in Rule G-18. That is, a broker’s broker would be required to make a reasonable effort to obtain a price for the dealer that was fair and reasonable in relation to prevailing market conditions. The broker’s broker would be required to employ the same care and diligence in doing so as if the transaction were being done for its own account.

Revised Draft Rule G-43(a)(ii) would provide that a broker’s broker that undertook to act for or on behalf of another dealer in connection with a transaction or potential transaction in municipal securities could not take any action that would work against that dealer’s interest to receive advantageous pricing. Under Revised Draft Rule G-43(a)(iii), a broker’s broker would be presumed to act for or on behalf of the seller[3] in a bid-wanted or offering, unless both the seller and bidders agreed otherwise in writing in advance of the bid-wanted or offering.

Revised Draft Rule G-43(b) would create a safe harbor. The safe harbor would provide that a broker’s broker that conducted bid-wanteds and offerings in the manner described in Revised Draft Rule G-43(b) would have satisfied its pricing duty under Revised Draft Rule G-43(a)(i).[4]

These provisions of the safe harbor are designed to increase the likelihood that the highest bid in the bid-wanted or offering is fair and reasonable. Many of the requirements of Revised Draft Rule G-43(b) would address behavior that would also be a violation of Rule G-17 (e.g., the prohibitions on providing bidders with “last looks” and encouraging off-market bids), although the requirements of Revised Draft Rule G-43 would not supplant those of Rule G-17.

Revised Draft Rule G-43(c)(i)(H) would require broker’s brokers that availed themselves of the safe harbor to use predetermined parameters designed to identify possible off-market bids in the conduct of bid-wanteds.[5] For example, the predetermined parameters could be based on yield curves, pricing services, recent trades reported to the MSRB’s RTRS System, or bids submitted to a broker’s broker in previous bid-wanteds or offerings.

Posted by Cate Long | Report as abusive

It’s true that there aren’t quote reporting requirements in the bond markets like there are in the stock markets. But that’s because there are literally millions of distinct bonds outstanding versus around 8,000 equities. It is impossible to quote all bonds actively as is done with equities. Dealers only provide bond quotes when their customers ask. And, there are detailed FINRA and MSRB markup and fair pricing rules that apply to the prices dealers dealers can charge for bonds. Moreover, the rules related to price transparency are completely unrelated to Gramm Leach Bliley and wouldn’t change if Glass Stegall came back. The GLBA had practically nothing to do with regulating the bond markets.

Even more important, there are extensive regulations that apply to almost all aspects of the bond markets. The SEC, FINRA and the MSRB all have thick rule books that relate to the bond business, and those rule books are getting thicker as Dodd-Frank is implemented. It simply isn’t the case that regulators conduct “little to no oversight of bond markets.”

Finally, under Glass-Stegall before the GLBA, banks were heavily involved in the fixed income markets. Government, agency, mortgage-backed and most municipal securities were all “bank eligible,” meaning that commercial banks could underwrite and trade them. Bringing back Glass-Stegall as it was before the GLBA wouldn’t keep banks out of the fixed income business.

Posted by DogFase | Report as abusive