U.S. Sen. Sherrod Brown long has had it right: Addressing the problem of “too big to fail” requires downsizing the nation’s largest banks. Unfortunately, the Ohio Democrat and allies, from both political parties, have not prevailed. Yet one tool the country has gained to help prevent banking excesses is the Volcker Rule, which regulators finally have approved, more than three years after congressional passage of the Dodd-Frank Act bolstering regulation of the country’s financial markets.
The rule is the idea of Paul Volcker, a former chairman of the Federal Reserve. He proposed a mechanism to restrain big banks from engaging in speculative trading, or taking substantial risks all while assuming the federal government would come to the rescue fearing that a collapse would bring broader ruin. Such a federal rescue mission essentially is what happen when Wall Street unraveled in 2008.
The big banks like to promote themselves as wise managers of risk, playing an indispensable role in allocating capital. The trouble is, they lost sight of prudence, lured by the big money in leveraging, risk getting out of hand, knowing they wouldn’t be permitted to fail. The Volcker Rule attempts to re-establish the presence of prudence, banks discouraged from such big bets, or “proprietary trading” that is driven by borrowed money and backed by little equity.
Think of the London Whale calamity, JPMorgan Chase losing billions in just this way. The episode helped proponents to overcome the arguments of banking lobbyists against the rule.
The Volcker Rule complements other aspects of financial reform, banks with more exposure to the costs of crises, facing more oversight such as higher capital requirements. If the Dodd-Frank Act doesn’t goes as far as Sherrod Brown proposes, it does contain a mechanism for winding down failed banks, something the Volcker Rule would make easier to achieve.
In aiming to make crises less dangerous, the rule reflects a telling distinction between risk to an individual bank and risk to the financial market as a whole, or even the economy. It reflects something along the lines of applying the principles of the former Glass-Steagall Act to contemporary banking, separating the hedging element from the more traditional work.
Can that be achieved without harming the financial industry, its impulse for innovation? Consider how the stock markets have performed, even with the Volcker Rule looming.
Crucial moving forward is achieving transparency. No surprise that banking lobbyists won concessions in the rule that invite gray areas, banks with an opportunity to pursue variations on proprietary trading that carry a similar and worrisome risk. How banks adapt won’t become clear until the rule has been effect for some time. Which puts the onus on regulators to watch closely and enforce the purpose of the rule.
They would do well to take their cue from Gary Gensler, the outgoing chairman of the Commodity Futures Trading Commission. He once was a Wall Street guy who took all that he knows and put it to effective use, the larger public interest advanced rather than the narrower desires of the biggest banks.