Volcker Strikes Back

One of the keen insights of the Great Depression was that you shouldn't combine safe, boring, deposit-banking with risky, testosterone-fueled proprietary trading. Doing so is like combining bread with rocket fuel: One may be necessary for daily sustenance, the other for cool aeronautics, but there's really no good reason you need to mix them.

Having learned their lesson, that generation passed the Glass-Steagall Act of 1933, which separated commercial and investment banking. It ensured that the banks with which we entrust our FDIC-insured deposits don't go off to Vegas with our money. If Wall Street wanted to gamble with its own money that would be fine, but it couldn't do so under the umbrella of a safe commercial bank with Federal guarantees.

It worked great
The economy flourished, we didn't have another financial catastrophe for decades, and it was awesome. While this separation was by no means the only safeguard that prevented a meltdown, it was a big help.

But over time, memories fade. Attacks on that separation began to escalate beginning in the 1960s, until it was ultimately repealed in 1999 so that Citicorp and Travelers could combine to form Citigroup (NYSE: C  ) , a one-stop "financial supermarket" concept that failed within a decade. Obviously a mistake.

Even John Reed, the chairman of Citi who got Glass-Steagall repealed, eventually apologized to the world:

I'm sorry ... We learn from our mistakes ... I would compartmentalize the industry for the same reason you compartmentalize ships. If you have a leak, the leak doesn't spread and sink the whole vessel.

In other words, it was a terrible idea
The decade after Glass-Steagall's repeal were the years banks really started going crazy, ratcheting up risk to increase profits, while imperiling their depositors, taxpayers, and the economy.

It's important to understand that proprietary trading is a secretive, risky business that's often funded by overnight shadow loans. The explosion of proprietary trading in derivative mortgage products at Federally insured banks drove up their leverage and short-term "repo" loans.

Financial sector debt rose from 54% to 114% of GDP, and repo loans increased three-fold. We saw a web of interconnected, bloated balance sheets that culminated in 2008 with $230 billion lost on just the very safest portion of their proprietary collateralized debt obligations.

You can see how this explosion in short term borrowings, indicative of shadow financing and risky proprietary trading, looks for the three largest deposit banks, Citigroup, Bank of America (NYSE: BAC  ) , and JPMorgan (NYSE: JPM  ) in the wake of Glass-Steagall's repeal:

Data from Capital IQ, a division of Standard & Poor's.

Data from Capital IQ, a division of Standard & Poor's.

Because proprietary trading is so secretive and the instruments so opaque, no one could tell the extent of anyone else's losses in 2007 and 2008. Banks withdrew their short-term financing to each other, and this freeze-up in the shadow financing market, you will recall, nearly took down the financial system by late 2008.

In other words, it was the gradual weakening and eventual repeal of the separation between investment (exciting, risky) and commercial (boring, safe) banking that juiced the risks Federally insured banks took, which made the crisis infinitely worse by imperiling basic payment mechanisms, our deposits, and the FDIC. It was for these reasons that the Motley Fool community voted the repealers of Glass-Steagall the people most responsible for the financial crisis.

Enter Paul Volcker
So in the wake of our Great Recession, what's being done to restore the basic Glass-Steagall separation between proprietary trading and commercial banking? One of the key parts of the financial reform bill currently being combined by the House and Senate is what's known as the Volcker Rule, named after the former Fed Chairman who is its champion.

The Volcker Rule is a sort of Glass-Steagall 2.0 would restore that hard separation between the two types of banking.

Now, there's a weak version of the Volcker Rule -- basically a Government Accountability Office "study" to think about the idea -- and a strong version -- the one being pushed by Volcker and Senators Merkley and Levin.

The strong Volcker Rule does three things:

  1. Separates commercial banking and proprietary trading so that in the future our bank deposits won't be backstopping trillion-dollar blind, drunk hedge funds.
  2. Requires higher levels of capital for risky investment banks whose failure would endanger the economy.
  3. Ends conflicts of interest whereby investment banks bet against the same securities they design and market, as Goldman Sachs (NYSE: GS  ) has been accused of doing. (Senator Levin compared the current rules to allowing your electrician to buy fire insurance on your home.)

Volcker understands that hedge funds and proprietary trading units can provide a legitimate service to the economy. But he also observes that such a high risk business doesn't have anything to do with taking and lending FDIC-insured deposits to support homebuyers, consumers, and businesses. Combining the two serves no social function, but it endangers everyone by ratcheting up the risk-taking and interconnectedness of banks that hold our deposits and process our payments.

Seems pretty straightforward
The strong Volcker Rule actually has support in both the House and Senate, but a small group of powerful House members are trying to introduce a loophole at the behest of Bank of New York Mellon and State Street (NYSE: STT  ) among others. They want federally insured banks to be able to invest some of their capital in hedge funds.

That would be a bad idea. Keep in mind this is the very same State Street that bailed out its stable value fund clients and off-balance sheet vehicles in 2008 before being bailed out by taxpayers the following year. Hedge fund sponsors also have a tendency to bail out their clients and then get bailed out by taxpayers. That's what happened to Bear Stearns in 2007-2008.

Even more ominous for supporters of the Volcker Rule, Senator Scott Brown is pushing hard for a loophole to let banks continue to invest in hedge funds and private equity as well as a seven year delay – basically to gut the entire thing. Volcker is absolutely opposed to the exemptions.

What do you think?
Is the tough Volcker Rule restoring the Glass-Steagall separation between deposit banking and proprietary trading a good idea? Should it have loopholes? Let us know in the comments box below.

And if you want Congress to know how you feel about the Volcker rule, here are their numbers. Simply tell the person who answers the phone that you'd like to comment on financial reform and tell them if you support a tough Volcker rule and what you think of the proposed loopholes:

Rep. Barney Frank, (202) 225-5931
Sen. Chris Dodd, (202) 224-2823
Rep. Dennis Moore, (202) 225-2865
Rep. Melvin Watt, (202) 225-1510
Rep. Greg Meeks, (202) 225-3461
Sen. Scott Brown, (202) 224-4543

Fool editor Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool is investors writing for investors.


Read/Post Comments (2) | Recommend This Article (24)

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 June 22, 2010, at 3:00 PM, Bot1 wrote:

    It seems that Congress is reluctant to pass the string Volker rule or a reinstatement of Glass-Steagall, not because it is the wrong thing to do, but because it would hurt bank profits.

    It was as if Congress had made bank theft legal for a period of time and then was reluctant to make it illegal again because it would hurt the income of the thieves.

  • Report this Comment On June 23, 2010, at 1:49 PM, acssgt316 wrote:

    Good article. I am disappointed that Scott Brown is among those sabotaging this bill.

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