From Economix

November 4, 2010, 5:00 am

The Volcker Rule After the Midterm Elections

By SIMON JOHNSON
Today's Economist

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The Obama administration saved the deeply troubled megabanks in the United States in early 2009 with a bundle of rescue measures that, compared with similar financial crises elsewhere, stands out as extraordinarily generous — particularly to the bankers at the epicenter of the disaster.

The banks responded to this magnanimity with — by all accounts — extraordinarily generous support for the Republicans leading up to this week’s midterm elections. Why would they do this?

The answer is straightforward: The Republicans have promised generally not to tighten restrictions on the financial sector, which means specifically that they will seek to make the recent Dodd-Frank financial regulatory legislation less effective.

The Dodd-Frank Act is not strong legislation to start with. The administration started with overly modest goals, and the banks then devoted considerable effort to weakening the bill as it passed through the House. But some pieces that survived have the potential to make a difference — including the Volcker Rule, which in principle would force big banks to get out of the business of betting their capital in ways that can bring down the entire financial system.

Paul Volcker, the former Fed chairman, came up with the ideas and helped shape the original proposed rule. This provision was pushed hard by Senators Jeff Merkley of Oregon and Carl Levin of Michigan, who prevailed against the odds in getting it into the bill, but now find regulators less than uniformly enthusiastic about applying the rule.

This brings us to the details — where all relevant devils reside. That your eyes may glaze over, is, as far as the banks are concerned, a desirable feature, not a bug. Comments to the Financial Services Oversight Council on how to put the rule into effect are due tomorrow; a few are already in, and more may be submitted at the last minute, in the hope of deterring rebuttal.

You can view the request for comment or search for the public submissions; when the site opens, click on the box for “public submissions” and a list of them will appear.

One comment, from State Street (on behalf of itself, Northern Trust and BNY Mellon), is instructive with regard to both substantive issues being debated before regulators and the broader political debate going forward.

The State Street argument is that the relevant section (§619) of Dodd-Frank could prevent a bank “from providing traditional directed trustee or similar services to its pension fund and other institutional clients.”

The issue, State Street points out, is “potential banks’ support for the investment performance of the fund” — that is, whether a bank would feel obliged to prop up the performance of a fund that is struggling. The problem with such propping up is that it will help a fund show better performance on average – and therefore help it attract more money — but it would also mean a bigger collapse, with much more devastating consequences, should subsequent problems arise (which is not so uncommon). Propping up is a fairly common phenomenon around the world.

State Street and its co-signers argue that banks such as themselves frequently do not have investment authority over plans for which they are trustees. But this is not the issue.

The real question is whether a custodial bank of any kind would have the incentive to prop up performance of a fund (of any kind). This is the way that banks can find themselves committing capital, whether they originally intended to or not. The sounder relationship between bank and fund is that when bad things happen, the bank is content to let the fund fail (or just show disappointing performance).

State Street and the other big banks mostly just want to be left alone. “We’re big boys and we can take care of ourselves” is their refrain – and you will now hear this echo far and wide, at least in the House of Representatives as we head into 2011.

This was exactly the operating philosophy of Alan Greenspan as Fed chairman, circa 1997: “As we move into a new century, the market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures” (quoted in “13 Bankers”).

The new century has not, so far, gone well, precisely because “market-stabilizing private regulatory forces” turns out to be an oxymoron.

And the specifics at stake here are far from hypothetical. Remember that Citigroup had large “off-balance sheet” housing-related liabilities that it ended up bringing back onto the balance sheet — thus absorbing the losses and forcing itself closer to insolvency. And even State Street had to prop up some of its “stable value funds.”

The designers of the details of the Volcker Rule — and their political masters — should not repeat Mr. Greenspan’s tragic and costly mistake. We need a real firewall between custodian banks and the funds with which they are connected in any form. The Volcker Rule, if properly and rigorously applied, can do just that.