President-elect Trump has promised to dismantle the 2010 Dodd-Frank financial law. Democrats have promised to keep it. The likely outcome is that the most controversial parts of the law will be altered by Congress or regulators. The Volcker rule, which Mr. Trump’s Treasury secretary pick, Steven Mnuchin, last week called “way too complicated,” would be a good place to start.
Named for former Federal Reserve Chairman Paul Volcker, an early proponent, the rule is intended to impose strict limits on commercial banks engaging in “proprietary trading”—i.e., investing bank capital to make speculative trading profits. Mr. Volcker himself thought a simple, four-page rule would suffice. Wishful thinking? The product of multiple financial regulatory agencies, the Volcker rule has ballooned to nearly 300 pages with more than 2,800 footnotes.
There is no evidence that proprietary trading caused or even contributed to the 2008 financial crisis. But like many financial products, especially making loans, there is substantial risk in proprietary trading. We believe this risk should be carefully and intelligently monitored and regulated.
The questions regulators are trying to answer are: Is the risk of holding an inventory of securities to enable customers to readily buy or sell securities through a bank reasonable? Or is the risk so excessive that changes in the market price of that inventory could put the institution in serious jeopardy?
Like any seller of products in any industry, it is perfectly logical that a financial institution would hold more inventory of a product to be sold to customers if it expects the price of that product might go up and hold less of it if the bank thinks the price might go down. We wouldn’t call this proprietary trading but rather common sense. Farmers and energy companies do it, as do manufacturers.
It’s foolhardy to try to get in the minds of traders at financial institutions to determine if the inventory they are keeping is larger than the expected demand. The solution to the problem is straightforward—simply limit the amount of “trading” revenue as a percentage of the firm’s total revenue to a de minimis level, say 10%. There is a precedent for this in the Federal Reserve’s decision to limit investment banking revenue of “Section 20 affiliates” as a percentage of total revenue during the 1990s when the Glass-Steagall restrictions were still in place.