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Slaughter & Rees Report - A 963-Page Quest for Financial Stability

December 16, 2013 --

It only took three-and-a-half years, but on Dec. 10 U.S. financial regulators voted to enact a measure that President Obama said “will help protect hardworking families and business owners from future crisis, and restore everyone’s certainty and confidence in America’s dynamic financial system.” This measure, commonly called the “Volcker Rule,” bans deposit-taking banks from trading for their own account (what is known as “proprietary” trading). It is the brainchild of Paul Volcker, the legendary former Federal Reserve chairman who often looks askance at modern banking. On numerous occasions he has said that, “The most important financial innovation that I have seen in the past 20 years is the automatic teller machine.”

Voting to enact the Volcker Rule triggered a flurry of reactions and forecasts that pretty much ran the gamut from preventing all future crises to crippling modern finance as we know it. We offer two points to consider.

First, the Volcker Rule will be devilishly difficult for regulators to implement. Distinguishing own-account trading from client-support trading will be challenging. Essential to its success will be judicious individuals who have the wisdom and authority to monitor and penalize institutions and/or individuals that violate ex ante rules. “A specific trade may be either permissible or impermissible,” commented Federal Reserve governor Dan Tarullo last week, “depending on the context and circumstances within which that trade is made.” “One of the most complex rulemakings I can remember,” similarly said the comptroller of the currency, Thomas Curry (and a supporter of the measure).

The Volcker Rule attempts to explain what constitutes “permissible or impermissible” trades spread across 71 pages—which are supplemented by a Tolstoyian preamble of 892 pages focused on how to comply with the measure. Interpreting these 963 pages will be economic stimulus for the legal and accounting industry. Will these 963 pages create more safety and stability in the financial system? We won’t know for many moons. The rule is not slated to be fully implemented until July 2015—and court challenges could push that date back even further).

Second, the Volcker Rule speaks to the difficult question of whether financial regulation should be more proactive or reactive. Proactive approaches, like the Volcker Rule, specify ex ante which activities are or are not permitted. Reactive approaches, rather than articulating detailed activity rules, focus on the absorption and/or resolution of activities that turn out poor ex post. Central here are mechanisms like capital reserves that allow banks to absorb losses on assets without being rendered insolvent: the Basel accords, which are broadly focused on ensuring banks maintain adequate capital buffers, reflect this approach to regulation.

Reasonable people can and do differ on the relative merits of these two approaches—and thus on the optimal balance a regulator should adopt between the two. They are by no means mutually exclusive. Indeed, last week Mr. Volcker also wrote supporting stronger leverage ratios. We caution against placing too much stock in proactive regulation, however, because generations of financial history are replete with cases of limited regulatory capacity to foresee future problems. However well-intentioned pro-active regulators may be, they are not omniscient. Rarely does the next crisis start either where the last one did or where lots of people have been looking.

While the Volcker Rule is often described as a solution to the problem of banks being “too big to fail,” let us all remember that in 2008 proprietary trading was not the cause of the financial crisis. We also remember another time of economic and market turmoil—precipitated by the bursting of the dot-com bubble and the collapse of companies like Enron and WorldCom—which gave rise to the Sarbanes-Oxley Act in 2002. That law was supposed to, as President Bush said, usher in a new era of fairness and honesty in business. Whatever Sarbox may have achieved, it did not prevent the financial crisis of just a few years later.

All reasonable people support policies that reduce the probability and expected damage of future financial crises. Time will tell how much the Volcker Rule is in this spirit. We wish it success, but we also urge regulators not to underweight large capital buffers and swift resolution mechanisms for ex post messes over ex ante eponymous rules.

Articles © 2013 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2013 Trustees of Dartmouth College. All rights reserved.

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