Paul Volcker Was Right Again

Before the ink was even dry on the Dodd-Frank Wall Street reform law, the financial industry predicted impending doom for the financial sector—and, by extension, the real economy—from the stronger equity buffers and tough new limits on high-risk financial trading mandated by the law.

Ever since, we have heard the steady drumbeat of industry fears that trading costs would spike, the costs of financing real economy businesses would rise, and a “liquidity crisis” would erupt.  Are they right?  Does tough financial reform strengthen markets and boost the real economy?  The answer is finally in, and Paul Volcker was right again.

For years, Paul Volcker and a few brave reformers—including President Obama, Gary Gensler, and Kara Stein—have argued that reforms would make our financial system and our real economy safer and stronger by focusing the financial system on quality. That means liquidity that is reliably available to support investment and trading, without leading investors into the “liquidity illusion.” This illusion that they can get out at any time without any price change can lead to speculative bubbles building and popping—in short, what happened in 2008.

Nevertheless, the industry and allies have continued to lead a full-fledged assault against financial reform on the grounds that liquidity in the bond markets would entirely dry up. They were so successful that the 2016 omnibus appropriations bill mandated the SEC study the impact of new capital rules and the Volcker Rule on liquidity in the Treasury and corporate bond markets—not a bad thing per se, but clearly a sign that someone is concerned.

Fortunately, we don’t have to wait for another study. According to economists at the Federal Reserve Bank of New York, the Financial Industry Regulatory Authority, and in academia, liquidity in the Treasury and corporate bond markets, post-financial reform, is as good or better than pre-crisis levels. The cost of borrowing, too, is at or near record lows. Indeed, far from a liquidity crisis, a major concern among economists and regulators has been potential overheating of certain parts of the credit markets.

This is not to say that everything is perfect. Transparency in the fixed income markets remains spotty and should be increased. This is particularly true in Treasuries, many parts of the repurchase agreement markets, and on compliance with the Volcker Rule. Investors would also benefit from enhanced disclosures around the prices they pay, and into the trading activities of institutions active in these markets. Market structure questions should also be examined closely, as electronic trading in Treasuries, the rise of ETF trading, and concentration may all be changing the way market participants interact.

In the very near term, few things are more important than finishing the Dodd-Frank Act’s implementation. It seems amazing that even as “The Big Short” dominates the silver screen, the SEC has yet to finalize the ban on designing complex financial products to fail that was put into the Dodd-Frank Act by Sen. Jeff Merkley (D-Ore.) and former Sen. Carl Levin (D-Mich.), along with the Volcker Rule.

Nor has it finished or stood up the regulation of credit default swaps, which played such an important role in the 2008 crash, or a number of important executive and incentive compensation rules.

In the end, we can take heart that a stronger regulatory regime is making our economy more resilient and our financial sector more competitive. Indeed, the stronger performance by the U.S. banking sector as compared to the European banking sector demonstrates, in part, the value of U.S. banking reforms. It also calls into question the wisdom of efforts in Europe to weaken bank capital buffers for securitization structures. Securitization has a useful role to play, but it should serve investors, not lower capital at banks.

Overall, undermining reforms by backtracking on higher equity buffers, tighter trading limits, or other tools such as risk retention to align incentives would be a mistake. We want a stable financial system to serve the long-term interests of the real economy. As Paul Volcker has said, for the good of the country we have to move forward.