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America’s national bank regulator, the Office of the Comptroller of the Currency, announced this month that it would seek to ease one of the most controversial parts of the 2010 Dodd-Frank Act, the Volcker Rule. Named after former Federal Reserve Chairman Paul Volcker, the rule bans commercial banks from “proprietary trading,” that is, trading with a bank’s own capital for profit.
Volcker Rule supporters argue that because a commercial bank’s deposits are federally insured, which puts taxpayers on the hook for a bailout, the answer is to ban proprietary trading to prevent taxpayers having to cover bank losses. As Paul Volcker said himself, “You shouldn’t run a financial system on the expectation of government support.”
But Volcker Rule supporters have landed on the wrong solution. While it’s true that governments have no business subsidizing bank risk, the fact remains that the Volcker Rule has done nothing to address this anyway. The real problem is not the proprietary trading — it is the federally insured deposits. If Congress really wanted to deal with the problem of risky banks, it would reform government guarantees, such as federal deposit insurance, rather than restricting what banks can and can’t do.
Note that proprietary trading is not so dangerous that all types of assets are banned across all industries. Instead, the Volcker Rule is riddled with exemptions. An explicit goal of the rule was to restrict the proprietary trading of only commercial banks, pushing the activities out to less-regulated hedge funds, which do not have access to federally insured deposits. Further, the rule doesn’t even restrict trading across all asset classes, allowing commercial banks to continue to trade in government securities. So it’s not that proprietary trading is innately too risky, as many like to claim; it’s that commercial banks are trading, in part, with deposits that are federally insured.
Risk, in and of itself, is no justification for banning proprietary trading. Although banks may be making risky investments with federally insured deposits by trading, banks also make risky investments with federally insured deposits every time they make a loan. Lending is itself a risk-laden bet, even with a bank’s own capital. The recent financial crisis clearly showed this. None of the commercial banks that failed did so because of proprietary trading. They failed because the mortgages they invested in, partly as a result of government policy, had become worthless.
Overall, the share of banks loan losses during the crisis was greater than the overall share of trading losses. It would therefore make just as much sense to stop bank lending to protect depositors as it would to stop bank trading.
Another problem with the Volcker Rule is it’s just about impossible to enforce as currently written. The rule’s definition includes exemptions that make it unworkable, either relying upon regulators to guess the intent of a trader, or to outright prevent activities that even the harshest critics regard as beneficial. This has even led Daniel Tarullo, one of the Federal Reserve’s lead advocates for the rule, to admit that “the Volcker rule is too complicated” to enforce properly and has likely made the situation worse.
Evidence shows that since the Volcker Rule has been in effect, banks have become no safer. Instead of improving the safety of financial institutions, the rule actually restricts opportunities banks have to hedge their risks and diversify their revenue streams. This only amplifies volatility and increases the likelihood of bank failures.
Instead of tackling the real problem of deposit insurance, Congress has done just the opposite. Under Dodd-Frank, deposit insurance has skyrocketed. In 2008 dollars, it increased from $40,168 per account in 1934 to $246,706 in 2010, Hester Peirce and Robert Greene of the Mercatus Center found in a 2013 analysis. This has led depositors to become less likely to monitor their banks and banks to be less careful since they are not being monitored.
It’s time for the government to stop subsidizing risk-taking. Mitigating financial instability will mean reining in the moral hazard of federal deposit insurance. This involves either scaling it back dramatically or privatizing it entirely. If Congress were serious about taking on risky banks, it would look to reform federal deposit insurance rather than stick with the conceptually flawed and unworkable Volcker Rule.
Daniel Press is a policy analyst with the Competitive Enterprise Institute, a free market public policy organization based in Washington, D.C.
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