The jewel in the Volcker rule

U.S. regulators are finally implementing the Volcker Rule, and it may prove the hidden jewel in the Dodd-Frank financial reforms.

The rule limits bank purchases of stocks, bonds, currency, commodities, and derivatives – contracts that bet on movements in the prices of assets – with their own money, which also put their federally insured deposits at risk.

Financial behemoths like JP Morgan Chase earn huge profits from such proprietary trading. Those help pay huge bonuses for traders but also create great jobs for many ordinary Americans. Unfortunately, trading distracts attention from the ordinary business of taking deposits and lending money to small businesses and homeowners.

It sounds reasonable. Encourage banks to be banks, again, by pushing them toward lending by prohibiting trading – essentially making bets with deposits that are ultimately guaranteed by taxpayers.

However, during the financial crisis, securities trading did not get the big Wall Street banks in trouble. It fact, the profits from trading kept many solvent when mortgages failed, and later when they paid big fines for misrepresenting mortgages sold to institutional investors.

Prior to the crisis, banks across the country made loans to finance homes buyers could not afford, and then bundled mortgages into bonds to sell to pension funds, insurance companies and other investors. When the latter figured out many loans would fail, banks got stuck holding too many bad loans and mortgage backed securities.

Once some mortgages failed, foreclosures snowballed and housing prices collapsed.

Other complex arrangements – like buying and selling derivatives intended to insure against too many mortgages failing contributed mightily to the morass – but it wasn’t JP Morgan trading in foreign exchange or Goldman buying and selling aluminium futures that caused the collapse.  In fact, that trading stayed profitable for even Citigroup, which headed the list of basket-case banks Uncle Sam had to rescue.

Today’s big Wall Street banks are not your grandfather’s banks. They are financial conglomerates that are both old fashioned commercial banks, and investment banks that help corporations sell new stock and bonds; brokerage houses that help the little guy invest; wealth managers for the portfolios of families rich enough to be corporations; and create markets in municipal bonds, foreign exchange, and other assets where no large public market exists or is sufficient.

Investment bankers learn a lot from those activities, and often buy and sell assets with their own money to profit. That makes markets function better and is a source of profits so huge they don’t have enough interest in making loans, especially to smaller businesses.

Unfortunately, Dodd Frank put such onerous and costly restrictions on ordinary bank lending that small town and regional banks have been selling out to larger brethren, and a handful of large big city financial conglomerates now control more than half of all U.S. bank deposits. As a result many smaller businesses around the country have lost their traditional sources of bank credit, hampering their ability to invest and create jobs.

Before the 1933 Glass-Steagall Act was repealed by Congress and President Clinton, investment banking and similar financial activities were kept separate from federally insured commercial banking. And that’s what needs to happen again, and the Volcker Rule could motivate just that.

As difficult as it may be for Jamie Dimon, CEO of JP Morgan Chase, to accept, now that the Volcker Rule makes it illegal for entities owning a commercial bank to engage in proprietary trading, it may be the best business decision for his firm to spin off its bank.

Chase Bank can stand on its own – and would better serve the economy as a bank focused on taking deposits, making loans and offering a range of consumer financial services – life insurance, retail brokerage services and trust activities.

Let JP Morgan be independent and wheel and deal – and in the process create wealth and jobs like few businesses, other than those in Hollywood and the Silicon Valley, can – but not with a government guarantee of its solvency. If it gets in over its head – let it fail.

Trading may be a bit like gambling but a bit of Las Vegas on the Hudson is good for America.

Peter Morici, an economist and professor at the University of Maryland Robert H. Smith School of Business, is a widely published columnist.