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What Should Congress Do About the Volcker Rule?

Earlier in November, Sen. Mike Crapo (R-ID), the Chairman of the Senate Banking Committee, introduced his much anticipated bipartisan financial reform bill, the Economic Growth, Regulatory Relief, and Consumer Protection Act. The legislation, which has 10 Democratic cosponsors, would bring decent relief to an industry that has been devastated under the weight of the Dodd-Frank Act, the Obama-era legislative response to the financial crisis. However, the legislation falls short in one key area: reforming the Volcker Rule.

The Volcker Rule is a Dodd-Frank regulation that prohibits federally insured banks from engaging in “proprietary trading,” which is trading with their own capital. It was first proposed as a remedy to the financial crisis, in order to prevent banks from speculating on securities with deposits that are insured by taxpayers. But as CEI Senior Fellow John Berlau and I argue in our new paper, “The Case against the Volcker Rule,” there is no evidence that proprietary trading played a role in the crash or that the regulation has made financial markets any safer.

The Volcker Rule was completely unnecessary to begin with. A look at the types of institutions that failed during the crisis clearly demonstrates this. The investment banks that failed, such as Bear Stearns and Lehman Brothers, had no commercial banking arms. They could not use federally insured deposits to make speculative bets. The commercial banks that failed did so because of subprime mortgage lending, not proprietary trading. As a 2011 Government Accountability Report found, there is no evidence of any bank failures that had resulted from standalone proprietary trading.

Yet the problems with the rule don’t stop there. When testifying before Congress, former Federal Reserve Chairman Paul Volcker—after whom the rule is named—said that proprietary trading is “like pornography,” as regulators would “know it when they see it.” But this is not so simple. The rule attempted to prohibit proprietary trading while allowing banks to engage in market making and hedging. But how is a regulator meant to determine whether a trader purchased a security to facilitate a future trade (market making) or speculate on its price (proprietary trading)? Only the trader knows what the true intentions were. This kind of arrangement, in effect, requires arbitrary decisions by regulators to enforce the law and discourages firms from legitimate trading.

Such problems have had major repercussions for the stability of financial markets. By inadvertently discouraging market making and hedging, the Volcker Rule has hurt the liquidity of corporate bonds. A recent Federal Reserve staff paper confirmed this, finding that the Volcker Rule has had “a deleterious effect on corporate bond liquidity and dealers subject to the Rule become less willing to provide liquidity during stress times.” If trading is affected by second-guessing against vague regulations, then instead of being absorbed by market liquidity, problems in the financial sector can spread quickly to the broader economy.

The answer is clear: Congress should repeal the Volcker Rule entirely. This could be achieved through the Senate passing the Financial CHOICE Act, a financial reform bill that passed the House in July. Short of this however, reform to the rule needs to go much further than what has been proposed.

Sen. Crapo’s legislation makes an incredibly slight reform to the rule—exempting banks under $10 billion in consolidated assets. But this does not go nearly far enough. Paul Volcker himself thought that the rule would only impact the largest four or five banks. Yet it has impacted everyone in the financial system, from banks and investors to businesses and consumers. If the Volcker Rule should exist at all, it should at least focus on the few largest firms that have significant trading activities—that is, Wall Street.

Markup of the legislation is scheduled for December 5. This gives senators the opportunity to raise the threshold where the Volcker Rule applies, up from a measly $10 billion.

Since the Volcker Rule was intended to tackle the trading of the very largest banks, an appropriate reform would be to integrate the rule into the regulation of Global Systemically Important Financial Institutions (G-SIBS), covering eight of the largest financial institutions. At the very least, the Volcker Rule could be integrated into the regulation of Systemically Important Financial Institutions (SIFI), currently covering all banks over $50 billion in assets.

Reforming the Volcker Rule would help bring about a more stable and efficient financial system, while providing relief to financial institutions, consumers, and investors. Congress now has the opportunity to do so at the Senate Banking Committee markup.