Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The Volcker rule

I wrote a column
in the Financial Express today on the Volcker rule and
other proposals of President Obama.

President Obama has proposed the ‘Volcker rule’
preventing banks from running hedge funds, private equity funds or
proprietary trading operations unrelated to serving their
customers. Simultaneously, he also proposed size restrictions to
prevent the financial sector from consolidating into a few large
firms. While this might look like unwarranted government meddling in
the functioning of the financial sector, I argue that, in fact, free
market enthusiasts should welcome these proposals.

Obama has chosen to frame the proposal as a kind of morality play
in which the long-suffering public get their revenge against greedy
bankers. While that might make political sense, the reality is that
the proposals are pro free markets. To understand why this is so, we
must go back to the moral hazard roots of the global financial
crisis.

These roots go back to 1998 when the US Fed bailed out the giant
hedge fund, LTCM. The Fed orchestrated an allegedly private sector
bailout of LTCM, but more importantly, it also flooded the world with
liquidity on such a scale that it not only solved LTCM’s problems, but
also ended the Asian crisis almost overnight.

LTCM had no retail investors that needed to be protected. The
actual reason for its bailout was the same as the reason for the
bailout of AIG a decade later. Both these bailouts were in reality
bailouts of the banks that would have suffered heavily from the
chaotic bankruptcy of these entities.

Back in 1998, the large global banks themselves ran proprietary
trading books that were also short liquidity and short volatility on a
large scale like LTCM. A panic liquidation of LTCM positions would
have inflicted heavy losses on the banks and so the Fed was compelled
to intervene.

From a short-term perspective, the LTCM bailout was a huge success,
but it engendered a vast moral hazard play. The central bank had now
openly established itself as the risk absorber of last resort for the
entire financial sector. The existence of such an unwarranted safety
net made the financial markets complacent about risk and leverage and
set the stage for the global financial crisis.

Those of us who like free markets abhor moral hazard and detest
bailouts. The ideal world is one in which there is no deposit
insurance and the governments do not bail out banks and their
depositors. Since this is politically impossible, the second best
solution is to limit moral hazard as much as possible.

If banking is an island in which the laws of capitalism are
suspended, this island should be as small as possible, and the domain
of truly free markets—free of government meddling and moral
hazard—should be as large as possible. Looked at this way, the Volcker
rule is a step in the right direction. If banks are not shadow LTCMs,
then at least the LTCMs of the world can be allowed to fail.

The post-Lehman policy of extending government safety net to all
kinds of financial entities amounted to a creeping socialisation of
the entire global financial system. The Volcker rule is the first and
essential step in de-socialising the financial sector by limiting
socialism to a small walled garden of narrow banking while letting the
rest of the forest grow wild and free.

What about the second part of the Obama proposal seeking to limit
the size of individual banks? I see this as reducing oligopolies and
making banking more competitive. Much of the empirical evidence today
suggests that scale economies in banking are exhausted at levels far
below those of the largest global banks, and there is some evidence
that scale diseconomies set in at a certain level.

There is very little reason to believe that banks with assets
exceeding, say, $100 billion are the result of natural scale
economies. On the contrary, they appear to be the result of an
artificial scale economy caused by the too-big-to-fail (TBTF)
factor. The larger the bank, the more likely it is to be bailed out
when things go wrong. It is therefore rational for a customer to bank
with an insolvent mega-bank rather than with a well-run small
bank.

This creates a huge distortion in which banks seek to recklessly
grow to become eligible for the TBTF treatment. Well-run banks that
grow in a prudent manner are put at a competitive disadvantage. This
makes the entire financial sector less competitive and less
efficient.

The Obama size restrictions will reduce the distortions created by
the TBTF factor, and will make banking more competitive. One could
argue that the restrictions do not go far enough because they
legitimise the mega firms that already exist and only seek to prevent
them from becoming even bigger. Nevertheless, it is in the right
direction. It does not undo the damage that has already been done, but
prevents further damage.

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2 responses to “The Volcker rule

  1. MT Fan January 26, 2010 at 10:55 pm

    And now Obama is a movie star. He is featured in a movie– exposing greedy hedge funds and market manipulation called “Stock Shock.” Even though the movie mostly focuses on Sirius XM stock being naked short sold to hell, I liked it because it shows the dark side of Wall Street. DVD is everywhere but cheaper at http://www.stockshockmovie.com

  2. cosmo January 28, 2010 at 9:37 pm

    Very well thought out and written.

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