The Argument for the Volcker Rule
Five financial regulators formally adopted a version of the "Volcker rule" today, banning commercial banks from the proprietary-trading business. You should read friends of the blog Mike Konczal and Matt Levine on this, who I think frame the debate well -- on this issue Konczal is a regulatory hawk, Levine a regulatory skeptic. Yet there are a few points I think Konczal and Levine both miss.
1. The Volcker rule isn't central to anybody's plan to re-regulate the financial sector. Nobody thinks this regulatory change is particularly important relative to say, raising equity capital requirements and leverage ratios, which are at the center of how people should actually think about financial regulation. This is important to remember because it narrows the field of relevant arguments for and against the Volcker rule. What matters is whether the marginal contribution of the Volcker rule after the other, more important regulatory changes is significantly positive -- that is, whether there is meaningful complementarity. (You'll notice this is the same line of thinking that goes on with the EITC and the minimum wage.)
2. It also matters because it makes the Volcker rule somewhat of a waste of time compared to unfinished business in financial regulation. I'm thinking of the risks that come from financial systems that are dependent on short-term borrowing, the risks in highly pro-cyclical credit ratings and asset risk-weighting, or the risks in too-dense networks of counterparties.
3. It seems everybody but me has forgotten the original, and I think still strongest, argument for the Volcker rule. It goes like this: (1) commercial banking should and will always enjoy the benefits of public insurance; (2) if a financial firm does both commercial banking and proprietary trading, catastrophic losses on the proprietary-trading side can create spillover effects on commercial banking, and it will be impossible to allow such a firm to fail; (3) therefore commercial banks would enjoy a de-facto public insurance on their proprietary-trading portfolios; (4) this problem is not resolved by raising equity capital requirements insofar as prop-trading losses could still cause public intervention to protect the commercial-banking side.
4. So there is some complementarity between the Volcker rule and the financial-regulatory approach that would be most effective. Yet I am not convinced that it is all that significant: How likely are prop desks to take unwise risks and exploit the moral hazard? How likely is the rescue scenario that creates the spillover and makes the Volcker rule necessary?
5. I don't think very much of the arguments that I've seen trotted around recently for the Volcker rule, which is motivating this post. The fact that prop trading is risky isn't unique -- and prop trading is not uniquely risky in any sense. This post is just a reminder that there is only one argument for the Volcker rule, and insurance spillovers between commercial banking and prop trading is it.