Defending a Strong Volcker Rule

Three years ago we were standing in the aftermath of the greatest financial implosion since 1929. High stakes gambling and risky bets gone bad on Wall Street had left our financial system near collapse and our economy in shambles.  This crisis had many causes—all man-made.

The Volcker Rule, as embodied in Merkley-Levin provisions of the Dodd-Frank Act, is a critical part of the effort to put in place financial rules of the road that will prevent another crisis like the one we experienced in 2008.

Put simply, the Volcker Rule takes deposit-taking, loan-making banks out of the hedge fund business. While hedge funds have their place in capital allocation, that place is not in commercial loan-making banks subsidized by FDIC insurance and the Fed discount window.  The reason is simple:  our banking system and our economy do better if the periodic bad bets of hedge funds blow up only the hedge funds and not our lending system that fuels economic growth and job creation.

In the years leading up to the Lehman Brothers bankruptcy, we had a culture where regulators –  and legislators –  rolled back protections that had shored up our financial system for 70 years.  In the aftermath of the financial crisis, the Senate Permanent Subcommittee on Investigations spent two years looking at the causes of the collapse.  And the world learned how this unregulated system broke down. Banks and other lenders made bad mortgage loans.  Credit rating agencies allowed those lenders and investment banks to package and sell those bad loans as triple-A-rated securities.  A shadow banking system had emerged without proper oversight or protections against runs.  And, we had massive financial firms making huge, leveraged bets on the whole mess – bets that brought big profits and big bonuses on the way up, but spectacular losses and bailouts on the way down.  And in some cases, firms rigged the game by selling their own customers products designed to fail and betting against them.

As we all know, in 2008, the house of cards came tumbling down. Even a series of massive bailouts were not able to prevent monumental economic consequences: $17 trillion in lost wealth, continued high unemployment nationwide, and one in four of America’s mortgages still underwater, three years after the crisis.  The instability in Europe today is in many ways a direct aftershock of the very same financial crisis.

In short, the narrow view that the financial system would regulate itself was clearly a dramatically failed experiment, and we are still suffering from the fallout.

Limiting the proprietary trading and conflicts of interest in institutions on which the “real,” Main Street economy depends was central to putting guardrails back on the financial sector.  That’s why Chairman Volcker, five former Treasury Secretaries (of both political parties), Nobel Prize winning economists, community bankers, and others supported our efforts to include the Merkley-Levin provisions in Wall Street reform legislation. Now, the question is whether proponents of the same failed ideology that created the crisis will prevent the rules from being implemented as we intended.

The regulators tasked with implementing the rule have come out with a proposal.  But that proposal seems to have created more questions than it answered.  And just before the New Year, regulators extended the comment period into February.  This rule should not be as vague or complex as they are making it.  And it should be implemented now.

Now that the taxpayer bailouts have helped restore the big financial firms’ profitability, they and their allies want to go back to business as usual.  They are already weighing in to tell the regulators just how complex and burdensome the Volcker rule will be, and how, really, this time the market will regulate itself just fine.  While market participants should have their views considered, and genuine issues should be addressed, we need to be careful.

Bad bets are not a thing of the past.  Just months ago, MF Global collapsed in weeks due to its bad bets on European debt.  Fortunately, it was neither a bank nor a systemically significant non-bank financial company, and while client money remains missing, its failure did not have economically systemic consequences.  But if those same bets were made in a bank or a larger firm, as they would be without the Volcker rule, such a collapse could be catastrophic for our economy.  Again.

MF Global’s meltdown should come as no surprise – high stakes investing is risky. There will be phenomenal gains and devastating losses – and that’s fine.  Both the gains and the losses can and should accrue to the private investors willing and able to take those risks. What is not fine is devoting public resources, like deposit insurance and discount window support, to private speculative profits. It’s not fine to put taxpayers on the hook for the losses when bets go bad.  And it’s not fine to jeopardize the economic well-being of homeowners, small business owners, and middle class families by risking the collapse of the banking system that they depend upon for credit.

The Glass-Steagall Act’s separation of commercial from investment banking offered a very clean way of preventing high-risk investing from threatening financial contagion that could infect the whole economy, but it is not the only way.  Market-making, underwriting, and wealth management are all client services that, with sufficient capital and proper regulation, can be conducted by a bank holding company without subjecting the company to inappropriate market risk.  But even these activities must be restricted, in a smart and effective way lest they be used as loopholes to continue making risky bets.

The Volcker Rule legislation was designed to allow for these legitimate client-serving activities without permitting them to be abused to circumvent the ban on proprietary trading.  As the regulators consider final rules, they need to do a much better job of drawing clear, bright lines and putting in place the meaningful tools for transparency and enforcement that America’s financial system needs to reestablish investor confidence and ensure America’s long-run economic health.  Congress has given regulators clear direction, but we need strong voices advising the regulators on the details to make the difference between a good, strong rule, and something watered down in the backrooms.

We urge any and all parties to investigate the issues, collect thoughts and insights, and weigh in through the rulemaking process. Comments on the proposed rule, due by February 13, 2012, can be submitted here. All interested should also feel free to contact the policy staff in my office to provide input and discuss comments.

Nobody wants to repeat the financial collapse, the bailouts, and the economic hangover we continue to suffer.  So we can’t afford to repeat the unfettered risky betting that contributed so much to them.  In addition to supporting the many other critical reforms presently underway, now is the chance for the American people to weigh in on the Volcker Rule to help ensure that we have the proper rules and limits in place so that our financial system can once again be an engine for real prosperity.