The Volcker Rule Won't Reduce Risk

The Volcker Rule Won't Reduce Risk
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After three years of regulatory wrangling, the Volcker Rule is finally out. The rule sharply curtails the types of trading activities that banks whose deposits are insured by the government can engage in. Volcker Rule supporters argue that it will make the financial sector a safer place. Don't bet on it.

First, consider the possibility that the Volcker Rule will successfully push risky trading out of the banks. If this trading is profitable, it will migrate to entities that are not subject to the Volcker Rule. The activity will move from the banking sector to the shadow banking sector, into hedge funds and other investment pools that are outside of bank holding companies.

Great, you say! No more gambling with federally insured deposits. Well, maybe not.

The second possibility is that banks will move their risky trades from their trading books, which are subject to the Volcker Rule, onto their banking books. So long as profits are realized over a period longer than 60 days, banking-book profits are not subject to Volcker Rule restrictions.

Trading-book positions include securities and actively traded assets that are re-valued each day as market prices change. Banking-book positions, loans and long-term holdings, are carried at historical cost with provisions for losses. In the esoteric world of bank regulation, trading and banking book positions are subject to different capital rules. Historically, trading-book positions had lower requirements, but Basel III has raised these substantially.

So how far-fetched is the second possibility? Not so far. Prior to the financial meltdown, many banks switched from holding mortgage loans directly to holding mortgage-backed securities, which were a core contributor to banks' losses in the crisis. Moving the mortgage risk from the banking book to the trading book generated capital savings. While capital savings will no longer be the prime driver of the profit calculation, nothing prevents banks from re-engineering positions so they can be held in the banking book, where outsized profits need not violate Volcker prohibitions.

The Volcker Rule also continues to allow banks to trade without restriction in federal, government-agency, and state and municipal bonds. Foreign banks operating in the U.S. can trade freely in their home country's sovereign debt -- no matter which country that is -- and U.S. banks operating abroad can trade in the local government bonds of the country they are operating in. While such bonds are normally low-risk investments, term-structure bets made with these bonds are not. Risky trading is apparently okay provided it helps to finance government debt.

Whether the Volcker Rule has any important effects will depend on how it is enforced. The Volcker Rule allows banks to trade for purposes of hedging or market-making. Banks can engage in thousands of trading-book transactions in a day, often hedging exposure in one corner of their portfolio with an offsetting position elsewhere. Keeping track of the reasoning behind each and every trade will be a complicated and expensive task.

What's more, risk management is not a perfect science. A bank might undertake a position as a hedge, but make a large unexpected profit or loss because of imperfections in its hedging models. Whether or not this will be a violation of the Volcker Rule will be a matter of regulatory judgment. In cases where regulators take action, the Volcker Rule adopts the IRS's standard of due process -- banks are presumed to be guilty until they prove themselves to be innocent.

Considering the sweeping changes that have taken place since the passage of the Dodd-Frank Act, it is difficult to see why the Volcker Rule should be necessary at all. The Dodd-Frank Act and Basel III have given regulators sweeping powers to regulate banks and keep them from taking excessive risks. Since the crisis, banks face substantially higher capital and liquidity requirements, semi-annual Federal Reserve-supervised stress tests and capital-plan reviews, annual orderly-liquidation-plan submissions, bank compensation "guidelines," new mortgage-lending rules, derivatives clearinghouses, and new government powers to address non-bank systemically important institutions. Even before these reforms came into being, regulators had authorities to mitigate bank risk that went unused. If regulators are on the job and exercise these new powers, do we really need the Volcker Rule too?

But the Volcker Rule is here, and it is becoming clearer how things may play out. First, to demonstrate their seriousness, regulators will accost some unlucky bank for the crime of making or losing some money on a trading position. The company will be fined, and its executive will face legal difficulties. Bank trading-book activity will move into less regulated institutions, and the shadow banking sector will grow. Next, the government's "Financial Stability Oversight Council," the entity created by the Dodd-Frank Act with sweeping authority to "protect" us from financial risks, will argue that the migration of proprietary trading has made the shadow banking sector a threat to financial stability.

The lobbying for new regulatory powers will begin again.

Paul Kupiec is a resident scholar at the American Enterprise Institute.

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