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The Volcker Rule and Congress' Unlearned Lesson

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Guest writer Nicole Gelinas is a contributing editor to the Manhattan Institute's City Journal, and author of After The Fall: Saving Capitalism From Wall Street -- and Washington.

The debate over the Volcker Rule, President Obama's proposal to force commercial-bank holding companies to shed hedge funds and prop-trading arms, shows that Washington is far from understanding the meltdown. The news that financial regulation is at an impasse, then, isn't so bad -- for how can Congress fix what it doesn't get?

The idea behind the Volcker Rule, as former Fed Chairman Paul Volcker told the committee last Tuesday, is that "commercial banks have an essential function in the economy, and that is why they are protected. But we don't have to protect more speculative activity."

But speculation is credit creation. The line between the two began to blur two decades ago as credit moved to the capital markets.

Which firm is doing "essential" banking? A small commercial bank that makes a mortgage and keeps the loan on the books, or a big-city investment firm that flips the mortgage on a prop-trading desk to make an interest rate profit?

Both are doing the same thing: supplying credit.

Volcker helped in this convergence, via a circuitous route
In 1984, Washington created the first "too big to fail" commercial bank, Chicago's Continental Illinois. With Volcker at the Fed's helm, the Reagan administration feared that the economy couldn't withstand Continental's failure, because the bank's reliance on short-term debt markets could cause disruption.

Washington stepped in and guaranteed all of Continental's creditors, not just insured depositors -- a watershed.

Volcker went before Congress and said that the decision was not a precedent. But markets knew otherwise. Commercial banks used their implicit government backing to compete with the lucrative securities world on its own turf -- and the investment world responded with its own weapon: capital-markets creativity.

By 2006, nearly 48% of household and business debt came through securitized debt, up from one-third of debt outstanding in 2000.

Soon, we learned what would happen if these markets staged a run. Starting in 2007, global investors dumped their AAA-rated securities, killing credit supply -- and killing the economy's demand for labor. The social cost of uncontrolled markets "working" was unacceptable -- just as it was in the 1930s at the old-fashioned banks.

The experience illustrates that what we learned in the '30s is still true. Washington must insulate the economy's vital stores of credit from inevitable financial-markets exuberance and panic.

Then and now
Eight decades ago, this task was easy. Banks were where the credit was -- so, regulate the banks. Congress created the FDIC, protecting small depositors so that banks could fail -- and benefit from market discipline -- without causing credit-destroying contagion.

Congress also forced banks to sell their securities businesses, so that the long-term loans that they held on their books -- the nation's credit -- would have some buffer against capital markets' acute optimism and pessimism.

As for the "speculative" securities markets: Congress' fix was to let securities firms and investors do what they wanted. The catch was that they could do so only within consistent borrowing limits, as well as trading and disclosure rules. They could blow themselves up without blowing up the economy with unpaid debt and hidden risks.

The separate-and-regulate strategy won't work today, unless Washington bans debt securitization and trading.

Volcker implicitly admits as much. He hasn't asked Congress to prohibit commercial-bank holding companies such as Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and JPMorgan Chase (NYSE: JPM  ) from underwriting or buying securities.

Debt securities have become too important for anyone to suggest a ban, or even, as government-support programs like TALF show, for the securities to disappear by themselves without extraordinary government support.

Congress can see that the Volcker Rule wouldn't work -- but it can't understand why. In the hearing, committee chairman Sen. Chris Dodd (D-Conn.) hinted at regulators' likely inability to differentiate between allowable "bank hedging behavior" and prohibited "profit-making trades."

But he skipped over the impossibility of distinguishing between essential credit that needs a government safety net and fun-and-profit credit that, Volcker says, doesn't.

Sen. Mike Johanns (R-Neb.) got Volcker to admit that the rule "certainly would not have solved the problem at AIG (NYSE: AIG  ) " nor at Lehman Brothers. "It was not designed to solve those particular problems," Volcker said.

But nobody seemed to understand why the economy needs protection from the panic that radiates from firms such as AIG.

The Senator who came closest was Chuck Schumer (D-NY). "We've securitized everything," he mused. "Everything got securitized. Credit card loans got securitized" and sold off to the markets.

"Whatever the place in Greenwich ... wasn't that large a company, but if the Fed didn't intervene ... we might have had the whole system unravel," Schumer concluded, referring to the 1998 rescue of the Long-Term Capital Management hedge fund.

Indeed, LTCM's uncontrolled failure could have precipitated a 2008-style "credit crunch" -- as nobody would have wanted to touch any debt security amid sell-offs and plummeting prices.

The question, then, is: How do we protect the economy from old-fashioned bank runs in the new-fangled credit world, without arbitrary bailouts that obliterate market discipline?

Washington must revisit the '30s-style rules for the old securities markets, not the banking side -- and apply them to new the modern debt-securities markets.

Solving "too big to fail"
One rule is consistent government limits on borrowing -- notwithstanding the perceived risk. Back in the 1930s, the feds didn't direct regulators to say, "OK, Woolworth stock is safe, so you can borrow 90% against that. RCA stock, not so safe, so you can only borrow 10%." The rule was across the board.

This time around, the government should similarly force financial firms -- from commercial banks to hedge funds -- to hold a consistent percentage of hefty capital behind all securitized debt, rather than giving some firms a break on AAA-rated securities and some firms a pass completely.

Such a rule would have slowed credit creation -- muting the bubble and the crash. Just as important, the economy would not have been so vulnerable to the government's top-down catastrophic mistake in assessing securities' risk.

The economy would not have been so vulnerable, either, to the government's similar mistake in deciding which financial firms are "essential" to credit supplies and which aren't.

A second necessary measure is consistent rules on trading and clearing. If AIG had had to put down $10 billion up front on a $100 billion derivatives liability, for example, and place the cash on reserve at a clearinghouse that had collected other counterparties' monies for the same purpose, markets would have known that some money existed to absorb losses.

Investors would have known, too, where the residual risk lay, and wouldn't have begun to pull from the entire system.

The difference between regulated and unregulated derivatives is why Barings (later bought by ING (NYSE: ING  ) ) could fail in 1995 without destroying the world's credit, but three years later, the Fed wouldn't take the risk with LTCM.

A third necessary rule is a capital charge for short-term borrowing. Banks and non-bank financial companies that rely on short-term markets inject an extra potential for market panic into the economy. It doesn't matter whether they have mostly long-term assets. When a firm's lending can dry up overnight, everything is mark-to-market.

If Congress enacts these three rules, it will have also solved "too big to fail." Lenders will know that financial firms can't hold the economy hostage by holding its credit supplies hostage -- renewing the most important regulation, market discipline.

Moreover, the rules would solve the "too big to fail" problem at commercial banks. Volcker confuses Congress when he implies that access to a limited public-safety net for commercial banks is a get-of-jail free card. Until the 1980s, it wasn't.

If commercial banks can't fail, no Volcker Rule, or any other rule, will rein them in. Their lenders will continue to lend without surveillance, and capital-markets firms will continue to unleash their weapon -- creativity -- in response.

Check out another of our guest columns -- this one by an actual third-party merchant on

Nicole Gelinas does not own any of the companies mentioned. The Motley Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (38)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 11, 2010, at 4:20 PM, BMFPitt wrote:

    The biggest problem is that Congress cannot be trusted not to bail out failed banks. And I have no idea how to mitigate that problem within the bounds of reality.

  • Report this Comment On February 11, 2010, at 6:47 PM, WilliamaA wrote:

    Mr. Volcker has not said exactly how to isolate the nation's deposit base from speculation. He has only said that is should be done. The details are many and there is more than one way to skin a cat, so he quite rightly has not interfered on this front.

    Furthermore, Ms. Gelinas may have some misunderstanding of the Volcker Rule. He has said nothing that would prohibit banks from selling mortgage-backed securities to get these assets off of their balance sheets. I'm sure he would be delighted. It is the buying of risky assets that would be controlled. This is more easily done than Ms. Gelinas or Mr. Dodd lets on. Regulators have dealt with this problem for decades, by creating certain assets that can be bought by a bank (low-risk assets necessary to position the bank's liquidity, some hedging instruments, some mortgages and a few other things). This is done in many countries, notably those that have managed to avoid the mega-crisis that has characterized the permissive regulatory environments that existed in the U.S. and Europe.

  • Report this Comment On February 11, 2010, at 7:59 PM, skat5 wrote:

    Congress did away with Glas-Steagal and the games began. It;s been great fun for those in the know, with their fat pay bonuses and their stellar status of being the Smartest Guys in the room. Creative financial engineering replaced responsible risk asessment just like any internet stock was bound to succeed in 1998 and the dow was going to go straight up to what? 100,000? People said this with a straight face.

    ENRON was not enough of a red flag?

    Investors dropped AAA when they discovered the rating had become a meaningless indicator of risk because so much of it was a bundle containing poison (debt with a high certainty of default, money lent to people who should not have been given credit for a wide variety of obvious reasons, by people whose job qualifications in some cases were no better than pizza delivery boy) but hey, its ok, the quality of the rest of the debt will cover this; sort of like saying its the same high quality Coach purse except some of the stitching was not done inside where it doesn't show. But hey, someone will buy it even if it is a fake.

    Derivitives? I freely admit I do not understand them. I see economists baldly state they have looked at some of them and they don't understand them. I get the impression that a derivitive could be something like someone taking an insurance policy out on someone they disliked and then lending them a defective bungee cord and driving them to a bridge and betting them a 6 pack they would not jump off. And hey, if they don't want the bet, give them the 6 pack if they can get somebody else to jump off, just tell me who before they do.

    The government should take over the rating function, and no one who does the rating can every be allowed to get a job with any corporation that has relied upon ratings as part of their business. The private ratings agencies were instrumental in wreaking confidence. Like streetwalkers with STDs, these guys would continuously lower their standards to keep the business. They helped spread their damage far and wide; no corner of the world was spared. Now of course, they are all too ready show how cautious they are. Better to get rid of them now before they get back out on the block.

  • Report this Comment On February 11, 2010, at 9:04 PM, CMFStan8331 wrote:

    "Sen. Mike Johanns (R-Neb.) got Volcker to admit that the rule "certainly would not have solved the problem at AIG (NYSE: AIG)" nor at Lehman Brothers. "It was not designed to solve those particular problems," Volcker said."

    The very last thing we need to do is pass some new rules that create an illusion of safety without delivering the goods. Fiddling around the edges is both pointless and dangerous - at least Ms. Gelinas is willing to tackle the larger problem.

  • Report this Comment On February 11, 2010, at 10:16 PM, jerryguru69 wrote:

    "The separate-and-regulate strategy won't work today, unless Washington bans debt securitization and trading"

    I am glad someone says that the real problem is the very existence of CDOs and MBSs.

    "Congress can see that the Volcker Rule wouldn't work..."

    and that even if Glass-Steagall still existed, I am pretty sure that it would not have prevented the financial meltdown.

    To the problem list, I would add the very existence of the CDS market: anyone can place a bet, even if you are not a principal in the underlying security. If a major counterparty (like LEH) goes belly-up, a reserve will not be enough to pay-off (AIG).

    However, I cannot see how your solutions will help. Let us say that Greece defaults on its bonds, and that huge-mega-bank has so much exposure, that the OCC declares it insolvent. It has:

    1) reserves on its securitized debt (which does not cover bonds issued by corp. or central banks?)

    2) reserves for its derivatives

    3) it pays charges for its short term debt.

    But, the short term market has dried up, and it simply cannot raise enough cash. Now what? Granted, the rules might decrease the chances of it having, but what happens when the events overtake the rules?

  • Report this Comment On February 12, 2010, at 4:32 PM, zonadude wrote:

    Wait a minute, this was a regulatory breakdown? Oh, well in that case, I guess the industry cannot regulate itself.

    But @jerryguru69, I don't think that the mere existence of CDOs and MBSs means that we cannot limit banks' activity in high-risk areas of investment. But if they sell these securities in a transparent fashion, then let the buyers beware. The whole point is that banks should not be allowed to overleverage their depositors' money. The banking business enjoys a high level of protection because of the desirable service it provides to the community. What they do for investors is a different issue altogether.

  • Report this Comment On February 13, 2010, at 1:02 PM, tweesner wrote:

    I am cautiously hopeful that there may at least be an emerging consensus that CDS's as know them are extremely bad things. Unless a CDS is limited to and inseparable from a specific security (i.e., unless the holder has an insurable interest at least equal in amount to the debt covered by the CDS), the CDS is a gambling contract and should be unenforceable, because it creates incentives to cause the harm insured against - e.g., shorting the security secured. (This is not a new idea: At one time, they were not enforceable on precisely this ground. Sometime around 1990 the rule was legislatively changed to accommodate the Wall Street crowd: the former rule should be restored as part of any financial reform legislation.)

    A second point: Ms. Gelinas' argument assumes that securitization is a good thing because it makes more capital available. It seems clear that securitization of debt meant that risk and reward were severed, which is unequivocally not a good thing. The ability of banks, mortgage lenders, credit card issuers, automobile lenders, leasing companies, etc., to get loans off their balance sheets via securitization, while at the same time earning substantial fees for originating and securitizing the loans, allowed, indeed fostered, a serious erosion of lending standards, as well as an uncontrolled explosion of liquidity - which brings us to the crash. For any financial reform to work, the original lender(s) in any kind of credit transaction should be required to retain a substantial percentage - at least 50% - of the credit to maturity, so the lure of origination fees does not outweigh the default risk. Such a limitation should apply to all regulated institutions, and any other large unregulated lenders, such as hedge funds and private lending pools.

  • Report this Comment On February 18, 2010, at 5:30 PM, rfaramir wrote:

    "The experience illustrates that what we learned in the '30s is still true. Washington must insulate the economy's vital stores of credit from inevitable financial-markets exuberance and panic."

    No, we need to go back further, before the creation of the Federal Reserve. President Jackson had some choice words for the National Bank he took down.

    The only way to preserve saver's deposits is not to allow bankers to treat them as the bank's assets and lend them out. Demand deposits should be bailments which the customer pays the bank to hold. Only money that a saver loans to the bank, like a CD or savings deposit, is then loanable (at a higher interest rate) to entrepreneurs to invest in business. Credit can be extended from actual owned or borrowed assets but it must NOT be created from thin air, or piggy-backed on top of assets that belong to someone else. When there are two claims on one dollar, that is fraud and electronic counterfeiting, plain and simple.

    With no bubble or boom, there is no crash. Without money being created we have slight deflation, which benefits everyone, especially savers and people on fixed incomes.

    I can see you are highly educated, but perhaps you need to study a little more widely: see for more.

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