VOLCKER HAS THE MEASURE OF THE BANKS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Volcker has the measure of the banks

By John Gapper

Published: January 27 2010 21:11

Since Paul Volcker stood by Barack Obama a week ago as the US president unveiled banking reforms devised by “this tall guy”, the “Volcker rule” has provoked angst on Wall Street and in Washington.

Critics complain that it is a populist measure designed to distract attention from the Democrats’ political woes; that it is impractical; that it would put US banks at a disadvantage to European ones; that its target is wrong; and that it would let investment banks escape.

Some of these objections, particularly the last, have weight, yet the Volcker rule – that deposit-taking banks would not be able to engage in proprietary trading, or to own hedge funds or private equity firms – is the first time any government has proposed a sensible structural remedy for the problems created by bailing out banks in 2008.

For that reason, I welcome the conversion of the US president to splitting up banks rather than letting them remain too big to fail and relying on tough regulation, higher capital charges and mechanisms for winding them down if they get into trouble. For the first time, a government is directly attacking the size and complexity of over-mighty institutions.

My colleague Martin Wolf raised a number of difficulties with the Volcker plan this week, and it does indeed, as he put it, need “more work”. But it would be a great shame if – as Wall Street hopes – it runs into the sand on Capitol Hill in the same way as healthcare reform.

There is clearly a populist element to the change in regulatory approach, which Tim Geithner, the Treasury secretary, resisted before the Democrats lost the pivotal senate election in Massachusetts.

But a law intended to elicit votes and popular support is only problematic if it is a bad law. A plan drawn up by a former chairman of the Federal Reserve and first suggested in a report from the G30 group of international banks is not a piece of political chicanery.

Nor do I see why it is impractical. Hedge funds and private equity funds are easy enough to split off from banks that have federal deposit insurance and official backing such as access to the Fed discount window. There is a case, which I discussed in an earlier column, for going further and taking asset management out altogether.

The definition of proprietary trading is trickier, given that any bank with market-making activities (which includes all the biggest ones) or Treasury operations (all of them) is positioning its balance sheet in order to make money, or at least not to lose it. But the reality is that most banks know what a proprietary trading desk is and the ones that do not find themselves suffering huge losses from rogue trading. It would be easy enough for executives and regulators to eliminate pure casino-style risk-taking.

Next is the objection that the Volcker rule is – like the Glass-Steagall Act before it – a US idea that does not fit the push for global co-ordination of regulation. France and Germany – despite their oft-expressed hostility to hedge funds and financial gambling – are never going to do anything to undermine their own universal banks.

Yet it is much better for the US to do the right thing than to wait for the European Godot. That need not be a problem for the US financial system – the Volcker rule would not curb innovation or stop hedge funds or private equity groups from making money. Curbs on large financial institutions are compatible with – indeed, can stimulate – a thriving financial sector.

A further objection to the Volcker rule is that it aims at the wrong target – that hedge funds and proprietary trading desks did not cause the crisis. This point is overstated: in fact, the crisis at Bear Stearns started with its own hedge funds, and many banks were in effect trading by holding triple-A mortgage-related derivatives.

It is also more generally misplaced. As Viral Acharya, a professor at New York University’s Stern School, argues, the crisis was caused by a “general underpricing of risk” that led many banks into taking on more trading and investment risk to boost their returns.

There is, however, one substantial objection to the Volcker rule as it has been structured by the administration. It focuses on deposit-taking banks rather than, as Mr Volcker’s G30 report last year phrased it, “systemically important financial institutions”.

This means that it would apply to, for example, JPMorgan and Bank of America, but probably not to Goldman Sachs and Morgan Stanley. These investment banks have the option of giving up their bank holding company status, shedding deposit-taking, and being able to continue combining proprietary and customer businesses.

Leaving aside the strange consequence that an attempt to curb banks could end up helping Goldman by reducing the competition, this is wrong in principle. Even if Goldman and Morgan Stanley surrendered access to the discount window and their bank status, do we really believe this deals with the problem?

Of course not, for we cannot (much as everyone would like to) erase the memory of the last time trouble struck. The Treasury was forced to bail out Goldman and intervene to prop up American International Group, the full details of which are now embarrassing Mr Geithner.

The Volcker rule is not perfect but is the best attempt yet to confront head on the legacy of that time. If it were extended to Wall Street as a whole, it would be better still.

Copyright The Financial Times Limited 2010.