Ezrati’s Economic Outlook: Volcker Rule Confusion

The bankers have argued against the rule on two levels. Without flows of funds from proprietary trading, they have said, markets will lose liquidity. Of late the European Commission has added its weight to the argument, fretting that lost liquidity will deepen Europe’s debt crisis. American bankers have also worried that limitations on American financial institutions will drive the issuers of securities to take their business abroad. The regulators have countered that other, non-bank institutions will expand to fill any gap left by banks. They have argued further that even if market liquidity were to suffer from the rule’s imposition, it would be small price to pay for a reduction in systemic risk. Because the rule also forbids banks’ positioning against customers, they contend that it will curtail predatory behavior. 

Even though it is impossible at this juncture to tell which side of this dispute makes the more powerful points, the rule has a still more fundamental difficulty in its internal contradictions. It seems incapable of distinguishing between dealing for clients, which the rule allows, and proprietary trading, which it forbids. Banks have to buy and hold an inventory of securities in order to meet client’s needs. Yet the rule cannot say when that client-oriented inventory becomes a proprietary position. Similarly, the rule offers no guidelines to determine when a bank has positioned itself against its clients and when simple prudence requires it to hedge its client-oriented inventory. Rep. Spencer Bachus (R-Ala.) captured the difficulty at the hearing when he suggested that the regulators had imposed on themselves the “tremendously difficult” task of determining “motive and intent.”