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December 11, 2011

A Strong Volcker Rule is Essential for Financial Reform

 

The Volcker Rule prohibits banks from proprietary trading, which is when they make big, leveraged, swing for the fences bets that juice their bonuses but sticks taxpayers with the bill if those bets don’t pay off.  This has generated tens of billions of dollars a year to the banks and most of that goes right to the bottom line and right into their pockets as bonuses.

As you can imagine, the banks, their allies and hired guns hate the rule and have been at war to kill or gut it since 2009.  Their legislative lobbying effort was fierce, but it survived and became a key part of the financial reform law signed by the President in July 2010. 

Now, after a year of yet more intense industry lobbying, the regulators have proposed a rule to implement the Volcker provision.  It is long and complex and, no surprise, the industry is attacking it again.  But, the key reason it is long and complex is due to the very same industry lobbying against other sensible reforms, which would have made the rule unnecessary.  Once it was clear that they couldn’t kill the rule, the industry then lobbied to load it up with exceptions, including 10 permitted activities like market making. 

Thus, much of the complexity and length is due to industry lobbying, but that hasn’t stopped it from relentlessly attacking the proposed rule as too complex and long.  Unfortunately, hypocrisy isn’t against the law.

We will be the first to admit that the proposed rule is far from perfect, but the rule requires coordination among five regulators and results from a process where industry input is overwhelming.  Given the lobby-laden political, legislative and regulatory process that rules go through, a perfect Volcker rule was never likely. 

But, for those who really care about financial reform and reducing the opportunities for the biggest banks to threaten the financial system and our economy as they did in 2008 (and, frankly, continue to do today), a strong Volcker rule is essential and we must all work to improve the proposed rule before it becomes final.

Regrettably, some reformers are criticizing the rule while ignoring how it got so complex and long.  Some are even calling for scraping the proposed rule altogether and telling the regulators to propose a less complex, shorter and better rule.  While I don’t doubt their sincerity, it seems inconceivable that reopening the rule-making process, which will inevitably include yet more massive, spare-no-expense bank lobbying, will produced a better rule.  I just don’t see it. 

Former FDIC Chairman Shelia Bair was one of the few heros during the financial crisis who repeatedly stood up to the big banks and their allies and she now has some good ideas for improving the Volcker rule.  In a recent column in Fortune magazine, entitled (somewhat misleadingly) “We Need a New Volcker Rule for Banks,” she made a number of sensible suggestions for improving the proposed rule.  For example, she stresses the importance of making bank executives and their boards personally accountable for compliance with the rule, which should be in any final rule.

Most importantly, her key point about what is needed for an effective Volcker rule can also be incorporated in the proposed rule before it becomes final: 

            “Regulators should scrap the mind-boggling complexity in the proposed rule and focus instead on the underlying economics of a transaction. If the transaction makes money the old-fashioned way — the customer paying the institution for a service through interest, fees, and commissions — then it passes the test. If profitability (or loss) is driven by the direction of markets, then it fails.”

While much of the complexity of the proposed rule regrettably cannot be scrapped, important parts can be changed to focus on the underlying economics of a transaction.  For example, the proposed rule should be changed to prohibit any compensation based on any revenue that results from a directional bet.  Only customer payments for a service through interest, fees and commissions should be allowed as part of anyone’s compensation. 

Take away as much of the compensation motive for proprietary trading as possible and many of the supposed problems with implementing the Volcker rule will, I bet, evaporate. 

Comments are due on the proposed rule by January 13 and Better Markets will be filing a comment letter, part of which is going to focus on compensation.  We have always had the view that a key way to identify and rein in system-threatening risks is to, as the famous saying goes, follow the money.  We will be urging the regulators to do just that.

 
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