Last week, the Obama Administration proposed two sets of new measures to contain systemic risk:  limits on financial firms’ size (as a fraction of market liabilities); and the so-called “Volcker Rule”, which would bar bank and financial holding companies from putatively high-risk activities like private equity investing, managing hedge funds, and proprietary trading. 

The Cambridge Winter Center has prepared a presentation that helps policy-makers evaluate the proposed Volcker Rule.

The presentation argues business models that combine elements of the commercial banking, broker-dealer, and proprietary trading business models can pose systemic hazards.  But the Volcker Rule focuses on the least problematic of those hybridized activities.  For sound market-based reasons, commercial banks are simply not involved in significant levels of private equity or hedge fund-like investing.

By contrast, broker-dealers (or investment banks) are quite frequently engaged in trading and investing for their own account -- both as a necessary consequence of their market-making function, but also as a means to capture incremental value.  Because investment banks (appropriately) fund themselves substantially in short-term and overnight markets, allowing them to take on volatile and illiquid assets is systemically dangerous.  Indeed, it was the proliferation of such “shadow banking” that was perhaps the single biggest driver of the credit bubble and ensuing crisis and government response.  But the Volcker Rule, as currently defined, does not apply to most investment banks.  Indeed, if the largest investment banks (Goldman Sachs and Morgan Stanley) were to give up their bank holding company status, the Volcker Rule would leave even them untouched.

The Volcker Rule can be improved, however.  First, policy-makers should focus their efforts on preventing too-big-to-fail firms (which are large broker dealers, not banks) from taking on credit and rate risk that their funding structures do not suit; the Volcker Rule should therefore apply to investment banks.  Second, rather than trying to define “proprietary trading” (such definitions are hard to create, and easy to get around), policy-makers should adopt a tailored approach to capital requirements.  For example, because inventories of securities that are disproportionately large compared to trading flow are more likely to represent proprietary risk, they might carry higher capital requirements.