Questioning the Volcker Rule

As I've mentioned before, Douglas Elliott at Brookings is among the most astutue analysts of the financial breakdown and the regulatory response to it. This recent testimony to Congress on the effects of the Volcker rule is the best commentary on the subject I've read.

As I will explain, I believe that the Volcker Rule is fundamentally flawed and will do considerably more harm than good for the economy. I base this on two decades on Wall Street as well as on the years I have spent examining federal policy towards financial institutions at Brookings and earlier at another think tank. Despite being a former banker, my views on the Volcker Rule do not stem from opposition to the Dodd-Frank reforms. Indeed, I am on record as a strong supporter of the overall approach of that legislation, although there are certainly things I would have preferred to see done differently.

My core problem with the Volcker Rule is that it seems to me to be trying to eliminate excessive investment risk at our core financial institutions without measuring either the level of investment risk or the capacity of the institutions to handle the risk, which would tell us whether the risk was excessive. Instead, the rule focuses on the intent of the investment rather than its risk characteristics.

This approach, says Elliott is wrong. What matters is not the bank's intent (insofar as you can measure it), but the level of risk relative to the bank's risk-bearing capacity. What is a "proprietary" investment, anyway? What is "integral" to modern banking and what isn't? Not easy to say.

Moreover...

by focusing on intent, we are almost certain to miss large swathes of investments that are taken on with an acceptable intent, but still represent excessive risk... As a public policy matter, we want banks, even small ones, to hold substantial portfolios of safe and highly liquid securities so that they can meet sudden demands for cash without having to make a fire sale of their loans or other assets... A large portion of the investment losses at commercial banks in the crisis were on their holdings of securities purchased for liquidity purposes. They bought mortgage-backed and asset-backed securities that were rated "AAA" and which were quite liquid until the financial crisis struck and rendered them illiquid. Thus, the intent would have been considered acceptable, but it did not prevent bankers from weakening their institutions by losing large sums of money.

These are good points and the whole (short) note is well worth reading.