It’s a seductive idea: Don’t let banks use deposits to fund speculation in securities. This was the principle at the heart of the Glass-Steagall Act in 1933 and is at the heart of the Volcker Rule recently advanced by President Obama. In this latter form, the policy says: Don’t let banks that take insured deposits engage in private equity investments, hedge fund investments or (most significantly) proprietary trading, i.e., speculation with the bank’s own balance sheet. Restricting this kind of risk taking seems to make sense at first look.
In reality, though, the Volcker Rule as proposed would do little good. It assumes that only institutions that take insured deposits need to control risk, and it assumes that the effective way to control risk is to segregate certain activities such as types of trading among separate types of companies. Both assumptions are doubtful, as I’ll explain below. It would be more sensible to say something like this: Don’t let any financial firm the government might have to bail out put itself at serious risk of failing. This is not at all the same thing.
Let’s take a close look at the first assumption, that only institutions that take insured deposits need to limit risk. Deposit insurance is a formal structure requiring the government (the FDIC in particular) to bail out the depositors in failed banks. But the government’s de facto commitment to the financial sector now reaches far beyond deposits. When the government bailed out AIG in 2008, as well as the entire set of large securities firms excepting Lehman Brothers, none had any insured deposits. In 1998 it organized the rescue of Long-Term Capital Management, a large hedge fund. Could the government credibly promise never to bail out Goldman Sachs if it didn’t take deposits? No one would believe it, nor should they. We are now living in a world of massive moral hazard, in which the government has shown it will bail out systemically important financial institutions whether they take deposits or not. Deposits are not the issue. We’re far past that point.
The second assumption, that the effective way to limit risk is to segregate activities among separate types of companies, is even more doubtful. Financial firms take risks in dozens of ways — by lending, trading and writing derivatives, the list goes on. A bank can lend, trade and write derivatives carefully and in moderation, or it can lend, trade and write derivatives recklessly. What matters is not the nature of the activity but the extent of the risk. In the prelude to the latest financial crisis, firms wrote terrible mortgage loans (Countrywide Financial, Washington Mutual), wrote terrible derivative contracts (AIG) and underwrote and traded terrible securities (Bear Stearns, Lehman Brothers, Merrill Lynch). All of these activities sufficed to sink the firms in question. There is nothing special about trading.
Furthermore, as many critics have noted, it is simply not possible to separate so-called proprietary trading from other forms of trading (for example, trading for customer account). All trading involves using a firm’s own capital to buy and sell assets quickly and in quantity — this is the central feature of any financial market. Those who avail themselves of financial markets include companies, governments, other traders — anyone who wants to transact. It makes no sense to try to separate trades according to the various motivations of traders.
And yet, the Volcker Rule is trying to get at something important. Let’s return to the central goal: Don’t let any financial firm the government might have to bail out put itself at serious risk of failing. These days the relevant universe of firms includes all financial companies large enough to be systemically important, not just those that take deposits. How do we prevent these firms from taking excessive risks, especially in boom times when such risks appear highly profitable?
A bank’s risk of failing has two dimensions: how good its assets are and how much owners’ capital is available to absorb losses on those assets. In the vernacular, bank risk is the interaction between asset quality and leverage. Bank regulation has historically put almost exclusive emphasis on leverage — this is the subject of the Basel Rules, an ongoing international agreement specifying the minimum capital banks must hold against various kinds of assets. The goal of these rules is to ensure that banks hold enough capital to absorb whatever losses they are exposed to. But the Basel Rules clearly failed to prevent the last crisis and, even if amended, may by themselves not be sufficient to prevent the next one.
Perhaps it’s time to implement another approach: focus on asset quality. After all, subprime mortgages and related securities of the careless sort promoted over 2003–2007 caused the last crisis. In retrospect, such securities were always too risky for banks. In fact, they were too risky for the borrowers as well. Perhaps we never want a sufficiently large financial firm to hold them regardless of how much capital it has.
An effective modern adaptation of the spirit of Glass-Steagall would place substantive limits not on activities such as trading versus holding but on asset quality — what gets traded or held. Regulators are very cautious about this. It runs counter to modern regulatory thinking to impose such limits.
But some such limits may be appropriate. To adhere to Volcker’s proposal, all private equity investments and many hedge fund investments are both illiquid and themselves highly leveraged. Volcker suggests — and is correct — that such investments are not appropriate for the balance sheet of any financial institution that might have to be bailed out by the government. This idea can be pushed even further.
For example, why not require all home mortgages held by large, systemically important financial institutions have at least 20 percent equity and adequate documentation? This would rule out many of the subprime mortgages at the heart of the recent crisis. It would have a political cost, of course. The subprime market grew primarily because the U.S. government wanted it to grow and aggressively stimulated it through directives to banks and to Fannie Mae and Freddie Mac, policies that were all very popular at the time.
So does government have the will to restrain this kind of risky lending, reversing its earlier posture? Time will tell. The current proposal, said to be reviving the spirit of Glass-Steagall, appears to have no political cost. There is no constituency for proprietary trading by banks except the discredited banks themselves. Unfortunately, as it stands, a ban on proprietary trading does little to make banks safer. Substantive restrictions on financial asset quality would go much further, giving the spirit of Glass-Steagall some modern substance.
David O. Beim is professor of professional practice in the Finance and Economics Division and a Bernstein faculty leader at the Sanford C. Bernstein & Co. Center for Leadership and Ethics.