Paul Volcker Defends Eponymous Rule

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Former Fed Chair Paul Volcker

Though the Dodd-Frank Wall Street reform act was passed way back 2010, much of the law remains to be implemented. One reason for the lag between passage of laws and their implementation is that when federal agencies propose new regulations, they are required to first seek public comment.

Monday was the final day that federal regulators were accepting comments on the so-called Volcker Rule, a regulation, first proposed by former Federal Reserve Chairman Paul Volcker, which bans federally-supported banks from making financial bets with their own capital.

Over the past several months, banks and other financial institutions have come out against the rule, claiming it would make financial markets less liquid, and American banks less competitive.

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Volcker came to the rule’s defense yesterday, submitting an eight-page letter to federal regulators. He writes,

“The basic public policy set out by the Dodd-Frank legislation is clear: the continuing explicit and implicit support by the Federal government of commercial banking organizations can be justified only to the extent those institutions provide essential financial services.”

Speculative trading, he insists, cannot be justified as an essential financial service.

Volcker goes on to argue that if the regulation would reduce liquidity in financial markets, it may not be an entirely bad thing. “At some point, great liquidity, or the perception of it, may itself encourage more speculative trading,” and encourage the kind of bubbles which precipitated our current economic malaise.

As for competition, Volcker dismisses the argument that banks would be at a competitive disadvantage if unable to trade speculatively with their own capital. He argues that banks that are prohibited from risky trades and highly leveraged balance sheets will actually be better able to lure depositors and those seeking financial advise or underwriting services.

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But Volcker doesn’t disregard all of the banking industry’s concerns. Much of the recent criticism of the rule revolves around what affect it would have on institutions which want to engage in ‘market making,’ rather than proprietary trading. A market maker is someone who holds an inventory of a certain kind of security, not with the intent of reaping speculative gains, but for the purpose of providing a venue for customers to buy and sell those securities, and making profit on the “bid-ask spread” (the small difference between the price at which you can buy and sell a security). Just like sellers of any other product, market makers reap small profits by serving as a middleman.

Volcker admits that a clear definition of what is and isn’t a market maker will prove “thorny,” and that the rule has the potential to prevent market makers from efficiently doing their jobs. But the former Fed chair believes that the benefits to the regulation outweigh potential side effects, and that with proper cooperation between industry and regulators, these side effects can be mitigated.