Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”
The Volcker Rule is intended to curb “proprietary trading” – specifically, high-risk bets placed by our largest banks. The Dodd-Frank financial reform act put it into law, and the relevant regulators have proposed a detailed and credible set of regulations to make it work. In accordance with typical administrative procedure in the United States, comments on these regulations were solicited. The deadline was this past Monday.
Today's Economist
Perspectives from expert contributors.
The legislative intent behind the Volcker Rule is clear – and reaffirmed in detail in the comment letter by Senators Jeff Merkley of Oregon and Carl Levin of Michigan, the co-authors of the relevant part of the Dodd-Frank legislation.
The reason that the general approach and this specific regulation makes sense, given past practices and likely future risks, is laid out in meticulous and convincing detail in the comment submitted by Dennis Kelleher and his colleagues from Better Markets.
The big banks and their allies are naturally fighting back. They like the implicit too-big-to-fail subsidies and are apparently offering to split those with people who will support
their positions in public (including some of my academic colleagues). Their collective lack of concern for the public interest is also natural, if somewhat callous.
But the executives of these companies have a fiduciary responsibility to their shareholders to make profits, and they interpret the too-big-to-fail subsidies as helpful in this regard. Government support, after all, allows these banks to borrow more cheaply and to take on more risk (gaining more when they get lucky, precisely because they have “downside protection” provided by taxpayers).
The Bank of Canada, that country’s central bank, would ordinarily be expected to take a broader perspective, at least aligned with the social interests of the Canadian population. The bank has a strong and well-earned reputation for safeguarding financial stability in the Canadian context, and its governor, Mark Carney, is the current chairman of the Financial Stability Board, the international body charged with coordinating efforts to prevent the global financial system from blowing itself up again.
(Mr. Carney was not in charge of the stability board during its long period of inaction and cognitive capture in the period preceding the 2007-8 crisis, when it consistently and excessively deferred to the “wisdom” of large global banks. According to his official biography on the Bank of Canada Web site, Mr. Carney worked at Goldman Sachs for 13 years but has not since 2003. I am not asserting and do not believe that this has anything to do with the issues at hand.)
In its letter, the Bank of Canada states that Volcker Rule provisions should apply only to entities that are or could damage American-insured depository institutions (see the last paragraph on Page 3). But we are far beyond worrying only about banks that have backing from the Federal Deposit Insurance Corporation.
In the post-Lehman and post-A.I.G. world, operating within the legislative framework of Dodd-Frank, smart regulators think in terms of “systemically important financial institutions.” What really matters is whether an individual bank or other financial-service company is so big or so important to the system that its failure could bring down many others. Some institutions designated systematically important have federally insured deposits; others do not (just as Lehman Brothers did not when it failed in September 2008).
The legislative intent of Dodd-Frank is most definitely to identify and limit system risk wherever it occurs, including outside the banking system. The Volcker Rule is just one essential part of this effort.
The Canadian authorities also appear to believe that the Volcker Rule would constrain the activities of Canadian banks in Canada. That is not my understanding, nor the views of experts with whom I have consulted. The Volcker Rule applies to American banks and to the American subsidiaries of foreign banks; regulators in other countries can decide what to do about their own banks at home or anywhere other than in the United States.
The more serious assertion made by the Bank of Canada is that disallowing proprietary trading by a handful of American megabanks would negatively affect the market for Canadian sovereign debt in a significant fashion (Page 2).
Writing in The Financial Times on Tuesday, Paul Volcker delicately but deliberately demolishes this absurdity. He points out that in the 1970s and 1980s, when he was one of this country’s most senior policy makers, Glass-Steagall and other regulations effectively prohibited proprietary trading and other securities trading by American banks. Mr. Volcker writes,
I do not recall — and I am morally certain it never happened — receiving a single complaint that the United States was discriminatory, that it damaged other sovereign debt markets or that it limited the ability of foreign governments to access capital markets.
Relative to the nuanced dialogue that usually takes place between current and former central bankers, this is a slap in the face. And Mr. Volcker is right to be confrontational.
The Bank of Canada provides no evidence to support its implicit proposition that American banks’ proprietary traders account for a large fraction of either Canadian debt outstanding or the daily turnover of that debt. The Bank of Canada needs to publish these data if its arguments are to be taken seriously.
Keep in mind that under the Volcker Rule, as proposed, American banks would still be allowed to hold Canadian sovereign debt and to buy and sell in the course of normal market-making transactions (as well as to underwrite the issue of securities in the normal fashion).
Only proprietary trading is being restricted, with the banks having great (and perhaps too much) leeway to define what is proprietary and what is market-making.
There is also inadequate consideration given to the obvious point: if the provision of liquidity in the market for Canadian debt is valuable, and if large banks will be less able to play this role (or will seek to charge a higher spread between the prices at which they buy and at which they sell such securities), then other firms and their traders should enter.
Just because Goldman Sachs wants to charge you a higher price – as its chief financial officer, David Viniar, has declared – does not mean you need to pay that price. Fortunately, there is still some substantial degree of competition in such markets (and if the Bank of Canada feels strongly to the contrary, it should push hard for an antitrust investigation).
The underlying Canadian argument, of course, is that its debt is just as safe as United States Treasury obligations (see the paragraph at the top of Page 4). But where exactly would we draw the line between “safe” and “not safe” foreign government debt?
We know that ratings agencies are routinely mistaken in their assessment of sovereign credit risk; this has been the case in almost every major crisis in recent decades (remember the AAA ratings on junk mortgage products?)
Canada is not alone in seeking an exemption from the Volcker Rule. The European Union would like an exemption for the debt of its member governments, yet Greece is already effectively in default, and several other countries are likely to follow (see my recent paper with Peter Boone on this topic). Some Japanese officials have expressed interest in an exemption from the Volcker Rule, yet Japan’s net debt is reckoned to be more than 120 percent of gross domestic product. This is a highly indebted country, and it would be foolish to grant any kind of waiver from the Volcker Rule to a country with such a high debt level.
If one or more foreign governments would care to indemnify the United States against losses incurred by our largest banks because of trading in those nations’ debt, this could be the basis of an interesting negotiation (see Dennis Kelleher’s suggested variant).
For example, would Canada be willing to pledge its International Monetary Fund quota – or other reserve-type holdings, preferably denominated in American dollars – to make good any losses classified under proprietary trading by big American banks (i.e., that would otherwise be covered by the Volcker Rule)?
Any such assets would need to be held in escrow, or there would be a very real risk that when the time came to collect, the countries in question would be unable to pay. For example, imagine what would now be the situation if American banks held a large amount of Greek government debt.
Or perhaps the Canadian taxpayer would be willing to subscribe to a new issue of convertible contingent debt issued by the likes of Goldman Sachs, Citigroup and JPMorgan Chase – allowing them to assume a “first loss” position whenever the management of such entities makes very big mistakes (or worse).
As Mr. Volcker put it bluntly in his Financial Times piece, “Let us not be swayed by the smokescreen of lobbyists dedicated to protecting the interests of some highly compensated traders and their risk-prone banks.”
The Bank of Canada should withdraw its comment letter. Alternatively, regulators in the United States should ignore such selfish interests of foreign governments, even when those sentiments come from the ordinarily sensible and responsible Canadians.