Of Frying Pans and Fires: The Insignificance of the “Volcker Rule”

February 10, 2010

By David J. Gernhard

The latest and greatest idea to come out of the Obama White House is the “Volcker Rule,” a proposed ban on a specific banking activity known in highbrow circles as propriety trading.

Banking is already one of the most regulated industries in America, and this rule applies to an area few know (or care) much about. But a brief history lesson can serve to put the Volcker rule in a far more meaningful context.

After the Great Depression, commercial banks were limited primarily to making money by lending to businesses and consumers the funds that had been deposited by their customers. The difference between the interest a given bank pays to depositors and the interest the bank earns from loans makes up the bank’s net revenue.

This changed in 1999. A law named Gramm–Leach–Bliley, after its authors, allowed commercial banks to earn money by using customer deposits to buy and sell financial assets (such as stocks and bonds). This process is known as proprietary trading, and there’s no question it contributed to the current woes in our financial system.

The Volcker Rule seeks to, among other things, limit the use of bank deposits to lending on the commercial and consumer loan markets – effectively putting an end to what is perceived as risky speculation in financial markets. Our public servants and state planners are arguing that proprietary trading is inherently risky and that banks shouldn’t be allowed to “gamble” with deposits for the bank’s profit.

Though this argument has teeth, it completely misses the point: the entire banking system is loaded with unnecessary risk. Government intervention in the form of cartelized fractional reserve banking and federal deposit insurance have perverted the decision making process of bankers. Even if federal regulators are successful in closing off one possible avenue for risky banking behavior, others will remain. Rather than scapegoating proprietary trading, we should be examining the entire corrupt system.

Profit decisions are made based upon perceived risk and reward. For any given level of risk, businessmen will invest in the highest return available. What happens, then, when federal policy socializes the risk across the entire nation? Bankers face dramatically lower levels of risk, but remain in position to capture all the returns from their actions.This skewing of risk/reward is caused by government intervention and privileges granted to our banks.

To understand this correctly, imagine that the government gave a particular class of citizens that were strongly oriented to making money, but were risk averse, the right to rob banks with impunity. All risks would be borne by other people, so the perpetrators would run no risk of being shot, arrested, jailed, or having their reputations ruined.  But the robbers could keep everything they stole. How do you think that would affect the number of bank robberies?

Rather than simply removing the advantages the state has given to banks, our political class wants to add regulations that give the appearance of reform without its substance. As we’ve already mentioned, this will only amount to a redirection of our system’s inflationary credit. Denied proprietary trading, banks will merely direct their resources toward other high risk/high reward opportunities. It’s like denying our hypothetical bank robbers above the opportunity to rob banks on Tuesdays.  Even if the rate of bank robberies goes down a bit, the basic problem of risk negation hasn’t been dealt with.

To get around the Volker Rule, banks would perhaps provide financing for riskier projects, lowering interest rates and lending standards. The effects on the economy would be identical. Granting loans and buying stock ultimately amount to the same thing. Both activities provide capital to businesses, lower interest rates, and inflate the economy. If the capital doesn’t truly exist – if it’s merely the byproduct of credit inflation and fractional reserve banking – then the boom/bust cycle will begin regardless of proprietary trading by commercial banks.

It’s worthwhile to point out that while this proposed rule won’t keep banks from engaging in risky loans, commercial banks would lose the liquidity of financial markets. If a bank needs cash fast, then having a position in relatively liquid financial assets is preferable to having the same amount invested in a risky business loan. Securities, because they are actively traded, are much easier to sell fast. Therefore, proprietary trading actually helps the bank remain solvent when facing a crisis.

Our current system is inherently risky and unstable. Its failure is due to governmentally granted privileges, not a free economy. True reform would remove the moral hazard of those privileges. Until that day, banks will continue to exploit fractional reserve deposit accounts in high-risk/high-return assets. Superficial changes in the areas where banks can seek high return assets won’t help our banking industry, and they might actually make it more unstable.