Volcker defends Volcker | FT Alphaville

Volcker defends Volcker

UPDATE: FT.com has just pubbed a Volcker op-ed, this one directly responding to European critics of his rule. A few lines:

There is a certain irony in what I read. In Europe, there are plans to introduce a financial transaction tax, justified in part by officials because it puts “sand in the wheels” of overly liquid, speculation-prone securities markets. For reasons analogous to those behind the Volcker Rule, the UK is planning to “ring fence” trading and investment banking from retail banking, creating airtight subsidiaries of larger organisations. The commercial banks responsible for what are deemed essential services to the economy will be insulated from all trading and only then will they be protected by the official safety net of access to the central bank, deposit insurance and possible assistance in emergencies.

That approach, as a matter of regulatory philosophy and policy, resembles the seemingly less draconian US restrictions on proprietary trading.

The simple fact is that Dodd-Frank specifically permits both “market making” in response to customer needs and “underwriting”. No doubt US banks will, upon request, be happy to provide those services to the UK and other governments. They can continue to purchase foreign sovereign debt for their investment portfolios – should I say à la MF Global? What would be prohibited would be proprietary trading, usually labelled as “speculative”. How often have we heard complaints by European governments about speculative trading in their securities, particularly when markets are under pressure?

A hat tip to Deal Journal for posting the text of the letter from Paul Volcker to the Fed defending his eponymous rule — click to open the pdf:

The letter hits back at the main objections raised by the rule’s critics, mainly representatives of the largest financial institutions and some foreign governments.

Volcker begins by summarising the main objections …

1. Proprietary trading by commercial banks is not an important risk factor;

2. Needed liquidity in trading markets will be imperiled;

3. The competitive position of U.S. based commercial banking institutions will be adversely affected;

4. The proposed regulation is simply too complicated and costly.

… before addressing each in turn. Item 2, the threat to liquidity, is the one we’ve seen come up increasingly of late, so we’ll excerpt his response to that one here:

As a general matter, efficient markets do need arrangements to facilitate trading in financial instruments. That ability to buy and sell large volumes of assets on short notice (termed “liquidity”) appeared, prior to the crisis, to be greatly enhanced. There should not, however, be a presumption that evermore market liquidity brings a public benefit.

At some point, great liquidity, or the perception of it, may itself encourage more speculative trading, even in longer-term instruments. Presumably conservative institutional investors are tempted to turn over positions much more rapidly, at the expense of careful analysis of basic values.

In the light of events, careful consideration of the benefits and possibly damaging consequences of increased liquidity has become the subject of new studies and commentary by economists and regulators. A consensus may be developing that beyond some point, little or no public benefit may be evident.

In any event, the restrictions on proprietary trading by commercial banks legislated by the Dodd-Frank Act are not at all likely to have an effect on liquidity inconsistent with the public interest.

The trading in stocks is still dominated by organized exchanges, and it is not the main focus of commercial bank trading activity. Trading in fixed-income securities and derivatives has become an important part of the activity of a few commercial banks over the past decade. Consequently, strong restrictions on proprietary trading (and on sponsorship of hedge and equity funds) under the new law present those institutions with a choice: give up either their proprietary trading activity or their banking license. The apparent reluctance to  do the latter only reinforces the perceived value of access to the Federal safety net and the substantial implicit subsidy to borrowing costs.

In essence, proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens. That, in essence, was the de facto distinction maintained until the last decade or two. Today, thousands of hedge funds operating with relatively little leverage and dependent on the equity capital of partners, represent much more limited risk to the financial system in the event of failure.

More responses to what is formally known as the proposed Prohibitions and Restrictions on Proprietary Trading and Certain Interests In, and Relationships with, Hedge Funds and Private Equity Funds available here and here.