Ever since the 2008 global financial crisis, the need for radical reform to financial regulation has been obvious. But the finance industry wants to minimise its regulatory constraints. The response to the proposed Volcker Rule, which would ban banks from proprietary trading, shows how hard the path of reform is. The Volcker Rule is due to become law in July, though its exact substance is still being debated.
Many different deficiencies contributed to the 2008 mess. But the huge cost of the various bailouts to save institutions whose failure would have threatened the whole financial sector has meant that 'too-big-to-fail' (or its variant, 'too-interconnected-to-fail') would have to be high on the reform agenda.
One response is to require systemically important financial institutions to hold more capital. When the re-jigged Basel capital requirements come into full force in 2019 this should help. But marginally more capital would not have saved the troubled institutions in 2008.
Bolder moves to restructure financial institutions have largely been left to individual countries. One approach is to separate out the non-core activities of the banks. Governments would still ensure that deposit-taking, simple credit provision and payments services were protected by tight prudential supervision and deposit guarantees. But other activities such as proprietary trading, underwriting, provision of derivatives, insurance, and funds management would be separated into entities which might feasibly be able to fail without threatening the whole of the financial system.
There are a couple of variants on this approach. The UK is exploring the idea of 'ring-fencing' the core activities to separate simple banking from other financial activities. The US is not attempting to return to the pre-1999 Glass-Steagall world when banks were largely confined to core banking activities, but the Volcker Rule would stop banks from carrying out proprietary trading: that is, buying and selling financial instruments (and position-taking) on their own account. Such activity has often been likened to a casino. There is a strong intuitive argument that this activity should not have the benefit of a government safety net.
While just about everyone agrees that too-big-too-fail is a serious problem, the proposed Volcker Rule has brought forth a torrent of largely self-serving opposition. Like all arguments put forward by vested interests, the criticism is couched as advocacy for the general good. The industry says it opposes the Volcker Rule not because it wants to preserve the government guarantee on their propriety trading (with the high salaries and bonuses involved), but because the rule will reduce liquidity in the market.
Not only is it considered legitimate to argue in terms of the public good, but the threat of prospective losses can be grossly exaggerated to bolster the case for the opposition: one estimate puts the losses at $US315 billion.
As well as the self-serving lobbying of the finance industry, some non-US regulatory authorities have been co-opted into opposing the Volcker Rule. The Japanese and the Canadian authorities have joined the protests. While the Canadians are concerned about possible effects on their own bond market, they also seem miffed that the Volcker Rule will impinge on Canadian institutions which are under their stewardship (and the Canadian banks certainly came through 2008 in far better shape than their US counterparts).
The Volcker Rule explicitly allows banks to carry out market-making in bonds, and banks can hold government bonds in their investment portfolios. Volcker himself expresses surprise at the hostile reaction to measures which he sees as much less restrictive than the Glass-Steagall regime, whose demise many see as an important cause of the 2008 crisis. Like any rule which attempts to restrict behaviour, there will be blurred borders between the permissible and the forbidden. Volcker acknowledges, as well, the need for fine-tuning in implementing the rule.
It's hard to judge how much of the complaints of the Canadian and Japanese authorities represent 'regulatory capture'; officials can become overly influenced by the insistent pressures of their own finance industries.
One thing seems pretty sure. Of the 16,000 responses provoked by the Volcker Rule proposal, the vast majority would be from the finance industry seeking to minimise restrictions on its activities. In this deluge of protests, the interests of the taxpayers, standing behind the explicit and implicit guarantees, will be under-represented.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.