Friday, February 24, 2012

Volcker Rule


“ne tirez pas le pianist”


Two-and-a-half years ago, much against the traditionally held belief, particularly in the western financial markets, that financial markets are inherently self-correcting, the banking system came to a near-collapse across the world. Such banking crises, of course, are mercifully rare—for rich countries, the crisis of 2008 was the biggest after the Depression of 1929. When everything is alright, banks are known to help economy grow, besides making life easier for people. For instance, look at India: when the banks in America and Western Europe are bleeding red, as a result of which the credit markets are almost frozen, Indians are enjoying easy loans for buying cars or homes from banks. The crisis has, however, alerted the regulators and political masters to put in place such regulations as would ensure a vibrant banking system all through, with no meltdowns across the globe.   

This whole episode has brought the colloquial term of the US financial markets, ‘Too big to fail’—that certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy, and therefore a government has the responsibility to support them when they face difficulty—to the forefront. According to the proponents of this theory, such institutions, being important, should enjoy beneficial financial and economic policy-favors from the governmentsBut such expectations result in moral hazard, for such protective policies tend to make a firm take positions that are high-risk high-return, since they can leverage these risks based on the policy preference offered by the governments. Hence, the critics of this policy argue that large banks should be left to fail if their risk management is not effective, while economists such as Paul Krugman hold that economies of scale in banks and in other businesses are worth preserving so long as they are well regulated in proportion to their economic clout, and therefore that too-big-to-fail status can be acceptable. Intriguingly, critics such as Alan Greenspan air a belief that such large organizations should be deliberately broken up. 

Similar is the belief of Mervyn King, Governor of Bank of England. He does not want them to play around with speculative investment banking activities against taxpayer-funded guarantees. It is strongly argued that combining high-street retail banking with risky investment banking or funding strategies by providing an implicit state guarantee against failure is not at all sensible. 

There is yet another argument: considering banks as the “super-spreaders” of financial contagion, everyone is today talking of puffing up banks’ capital cushion. Here again, there is a doctrinal opposition:  higher capital standards may slow growth. According to the New York Fed Reserve, for every percentage point of extra capital that banks should hold, the economic growth might slow down by about 0.09% per year. But the question is: How much capital is sufficient enough to make banks safe? There is no agreement on this issue. That aside, there are some economists who opine that raising capital standards by itself cannot achieve much, for banks will absorb it easily and continue merrily to use the savings for even proprietary trading and whatnot.  

It is against this background that Paul Volcker, the former Federal Reserve Chairman, proposed banning proprietary trading—which is often viewed more as a speculative act—by the American banks, and the same is embedded in the Dodd-Frank Act as a Rule, which is, of late, being dubbed as “Volcker” rule. The Rule, of course, offers an exception: it permits banks to continue with their ‘market making’ and ‘underwriting’ activities in response to customer needs.

As could be anticipated, it generated an outcry from the non-US banks, particularly those operating in the US. They accuse that “Volcker [rule] acts like a giant set of handcuffs on foreign banks.” Even the representatives of governments aired a feeling that “the rule could curb their ability to fund themselves in government bond markets.” There is, of course, a grain of truth in the foreign government representatives’ accusation that the rule has “double-standards”, for the exception under the rule for market making and underwriting is available only for activities related to the US treasuries. Many critics of the rule also state that it will be difficult to distinguish proprietary trading from trading on behalf of customers. There are, of course, some, such as public pension funds, that are supporting the rule since they believe that it minimizes the systemic risk posed by large financial institutions. 

Obviously, Volcker is surprised at this outcry, for he strongly believes that proprietary trading does not matter for the stability of commercial banks, nor does it matter in framing “compensation practices” or in ensuring desirable “fiduciary culture” in financial institutions.   His sole argument is that these traders from banks undertaking proprietary trading in large volumes “should not have access to the taxpayer support implicit in the safety net of commercial banks.” In support of his Rule, Volcker raises a question: “How often have we heard complaints by European governments about speculative trading in their securities, particularly when markets are under pressure?”

That said, he, admitting how complex it is to resolve the too-big-to-fail syndrome, invites a degree of consensus among the national regulatory authorities to arrive at a common approach in reforming the financial system. He further states that as we go ahead with the new rule, any frictions arising out of it can be addressed to eliminate the unintended consequences. He, therefore, urges that no one should get swayed by these lobbyists who are only “protecting the interests of some highly compensated traders and their risk-prone banks.” And there is a final point in his argument.

A dispassionate reading of the whole episode, perhaps, advices us: “ne tirez pas le pianist”—“Don’t shoot the piano player.” For, it intends to do the best for the ailing global banking system.
 GRKMurty

Keywords: Volcker Rule, Paul Volcker, Banning Proprietary trading in banks 
Image courtesy:  
http://static7.businessinsider.com/image/4cc6dc90ccd1d545520c0000/paul-volcker.jpg

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