Repeal Dodd-Frank’s Senseless Volcker Rule

Thursday, 20 Jan 2011 10:45 AM

By John Berlau

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On Tuesday, President Barack Obama, to use a well-worn cliché, surprised both his friends and his enemies by acknowledging that overregulation can have high costs to the economy. 

In an Op-Ed that ran on the free-market editorial page of The Wall Street Journal, Obama wrote that some regulations do indeed place “unreasonable burdens on business — burdens that have stifled innovation and have had a chilling effect on growth and jobs.”

But so far, this “change in tone” is merely rhetorical. In the same Op-Ed, Obama hedged by defending what he called “common sense rules of the road,” and didn’t acknowledge any unnecessary regulatory burdens from the slew of legislation enacted by the last Congress, such as Obamacare and the Dodd-Frank “financial reform.”

With regard to the latter, on the same day the WSJ ran Obama’s Op-Ed, the Financial Stability Oversight Council issued recommendations for implementing the costly and burdensome Volcker Rule, the provision of the Dodd-Frank financial legislation that bans so-called proprietary trading by banks.

If Obama were to follow his Op-Ed’s admonition to “root out regulations that conflict, that are not worth the cost, or that are just plain dumb,” he would lead the effort for the Volcker Rule’s repeal.

Before it has even been implemented, this senseless rule is already showing signs of doing lasting damage to the economy and which will most likely add, not lessen, systemic risk.

The Volcker Rule is based on the faulty premise that a financial institution making a loan — any loan — is somehow inherently more dangerous than investing or trading. It was that premise that led to the enactment of Glass-Steagall in the Depression that separated “commercial” from investment banking.

After evidence of the damage that Glass-Steagall was doing to U.S. competitiveness plus empirical studies that showed it did not protect the financial system from systemic risk, the Clinton administration and a large bipartisan majority in Congress largely repealed it in 1999.

Yet bad ideas have a way of coming back to life, and Glass-Steagall’s repeal was falsely blamed for the financial crisis — a crisis primarily caused by lax lending standards on traditional mortgage loans — loans bought by the quasi-government entities Fannie Mae and Freddie Mac and encouraged by laws such as the Community Reinvestment Act.

As Peter Wallison, fellow at the American Enterprise Institute and a commissioner on the congressionally created Financial Crisis Inquiry Commission, has written, the commercial banks that imploded all went bust “by investing in bad mortgages or mortgage-backed securities, not because of the securities activities of an affiliated securities firm.” (Wallison and some of his fellow commissioners are expected to detail the amount of bad loans influenced by government rules in their final FCIC report, which may be written as a dissent.)

The Volcker Rule restricts banks, and in some cases insurance holding companies, from "proprietary trading” — which it defines as trading for the institution itself rather than for its customers. But this is based on a similarly false premise.

There is nothing inherently more risky about trading — short term or long term — than making loans. Supporters of the Volcker Rule say banks shouldn’t be “gambling” with taxpayer money, and indeed deposit insurance should be reformed and gradually phased out so that all institutions as well as savers and investors are more risk conscious.

But policymakers must recognize that every time a financial institution engages in an economic transaction — whether a loan or a trade — it is making a “gamble” that it will never get its money back. Limiting a bank’s ability to take equity in a firm by saying it can lend but not invest to that particular firm will result in less, not more, protection from risk.

And already, the Volcker rule may be hindering economic recovery. John Maggs reports in Politico that banks are losing top traders to hedge funds, because of uncertainty about the rule. Banks ability to “make markets” for investors by buying a particular security may be sharply restricted, which in turn could slow down the formation of new businesses that create new jobs.

And even though this supposedly was taken care of by giving regulators more flexibility, there is still concern that the rule will affect many insurance companies’ investments in blue-chip stocks. These are investments that are encouraged and even required by state insurance commissioners as a way for companies to diversify their investments for solvency.

The Oversight Council called for some latitude in allowing banks to buy securities for market-making, and, if adopted, these recommendations may blunt some of the rule’s worst potential economic effects.

But due to unnecessary restrictions and uncertainty that will still linger, Congress should repeal the misguided Volcker rule and move on to the Dodd-Frank “financial reforms” glaring omission — the behemoths Fannie Mae and Freddie Mac, which were at the center of the crisis.

John Berlau is director of the Center for Investors and Entrepreneurs at the Competitive Enterprise Institute. He blogs at OpenMarket.org.



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