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Bair Recommends Scrapping the Volcker Rule

If you needed to appeal to one authority on banking regulation, you could do worse than to consult Sheila Bair, the former chairwoman of the FDIC. And now she’s advocating scrapping the Volcker rule and starting over. She comes at this by looking at the spectacle of MF Global – a brokerage house that would not be covered under the Volcker rule – and asking whether they would be permitted to trade depositor funds on their own account if they were a bank. The answer is far less clear-cut than it should be – and that’s the problem with how the Volcker rule emerged from the sausage grinder of the regulatory apparatus.

MF Global took proprietary positions in European sovereign debt through what Wall Street calls “repo to maturity” transactions. It technically sold the European bonds to other firms, agreeing to repurchase them at a premium when they matured in 2012. MF hoped to make money by pocketing the difference in the rate it paid its trading partners and the higher rate paid on the bonds themselves. As market prices on the bonds fell, MF Global’s trading partners demanded more collateral. Given MF’s extreme leverage — about 40 to 1 — the collateral calls quickly brought it down […]

Under the 300-page Rube Goldberg contraption of a regulation recently proposed by federal agencies to implement the Volcker Rule, “repo” transactions like MF Global’s are not generally treated as verboten proprietary trades. Thus, even if MF Global had been a bank, it arguably could have used this exception to gamble away, putting the FDIC at risk. Indeed, the proposed rule has so many loopholes that seem to permit proprietary trading with government-insured deposits that former MF Global CEO Jon Corzine might consider commercial banking for his next career move.

Bair sympathizes with regulators trying to draw a very difficult line on proprietary trading. But she says that the drawing of that line is the entire problem with the rule. Too many exemptions and allowances for market-making have turned the Volcker rule to mush, and in Bair’s opinion, it’s become impossible to salvage.

So here is an idea. Regulators should scrap the mind-boggling complexity in the proposed rule and focus instead on the underlying economics of a transaction. If the transaction makes money the old-fashioned way — the customer paying the institution for a service through interest, fees, and commissions — then it passes the test. If profitability (or loss) is driven by the direction of markets, then it fails. Inevitable gray areas, such as market-making, need to be done outside of the insured bank and be supported by a truckload of capital. Securities firms should be allowed to maintain adequate inventory to make liquid markets.

Most important, regulators should tell executives and boards that they will be held personally accountable for monitoring and compliance. Bank leadership must make clear to employees that they are supposed to make money by offering good customer service, not by speculating with the firm’s funds.

I think the response to this is that we don’t just need new rules but new regulators. The Volcker rule embedded in Dodd-Frank, which generally came out of the Merkley-Levin amendment, had far more bright lines than the draft version released by the regulators. Congress did their job, not perfectly, but in enough of a way to spook a lot of big players out of the prop trading market. The regulators, influenced by Wall Street, destroyed the Volcker rule. So a new rule based on the underlying economics only works if you have diligent regulators – thousands of clones of Bair, essentially – setting the rules of the game and engaging in vigorous enforcement. Otherwise, the whole thing falls apart.

Bair says that if the regulators cannot structure a simpler Volcker rule, maybe Glass-Steagall (32 pages of simplicity) needs to be reinstated. Certainly. The more clarity, the better.

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David Dayen

David Dayen