Recent Congressional hearings on the Volcker Rule made one thing clear: Of all the many provisions of the Dodd-Frank financial reform legislation, this one, which would forbid banks from trading securities on their own account, remains the most contentious. Though much of the dispute over the rule has revolved around issues of liquidity in securities markets and the international competitiveness of American finance, a more fundamental problem lies in the proposal’s inherent and debilitating ambiguities.
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.”
Yet for all this ambiguity, regulators seem to have few plans, if any, for drawing clear guidelines. They acknowledged these difficulties at the hearings. Federal Reserve Governor Daniel Tarullo admitted the extreme difficulty of drawing the “distinction between prohibited proprietary trading and permissible market making,” and Securities and Exchange Commission Chairman Mary Schapiro reassured all that her agency had no plans to sanction banks that unintentionally run afoul of the rule. But neither these two nor any of the other regulators at hearings offered insight into how they would overcome these basic ambiguities. The best they could do was imply that they could work things out in time.
It is unsettling enough that financial reform is proceeding in such a vague way, but even more troubling is the ambiguity’s invitation to inconsistent and, unavoidably, inequitable enforcement. In the absence of clear guidelines, individual regulators will have to rely on their own judgments, and these could differ widely from agency to agency, case to case and examiner to examiner. For the regulated, this uncertainty alone could drive many out of the securities business altogether. Others, faced with such unpredictable legal risks, could so restrain themselves that they become ineffective agents for their clients. A loss of market liquidity from these causes would be harder to dismiss than the bankers’ more obvious points. Certainly such a situation would drive business away from American firms and markets to foreign competition and foreign markets.
Neither does the record of rule making to date offer much reassurance that regulators will clarify matters any time soon. Part of the problem is the Dodd-Frank legislation itself. By assigning rule development and enforcement to five overlapping and jealous jurisdictions—the Fed, the Federal Deposit Insurance Corp. (FDIC), the Office of the Comptroller of the Currency, the SEC and the Commodity Futures Trading Commission (CFTC)—it has invited dispute and all but ensured vague compromises. The infighting has become so severe that these agencies squabbled last October over which would vote first on the rule. Even as the regulators tried to present a united front at the hearings, fundamental disputes remain. The FDIC, for instance, wants bank executives to vouch personally for their firm’s compliance, a practice called “CEO attestation,” and it wants to force banks to turn over a battery of trading data for monitoring. The Fed and the Comptroller’s office fiercely resist both proposals.
Whatever the fundamental merits of the Volcker Rule as former Fed Chairman Paul Volcker meant it, the lack of clarity in the present effort promises confusion among regulators and regulated alike and threatens more harm than help. Perhaps, as former FDIC Chairman Sheila Bair suggested, the regulators would do well to scrap what they have and start again.
Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo.