ProfessorBainbridge.com

Just in case you thought bringing back Glass-Steagall is a good idea

Consider how much trouble the regulators are having writing the Volcker rule:

In October of 2011, the SEC, CFTC and the banking agencies issued a joint notice of proposed rulemaking to implement the Dodd-Frank version of the Volcker Rule. In a clear sign of the trouble regulators are having, noted House Financial Services Chair Spencer Bachus (R-ALA), their joint proposal runs 300 pages and asks more than 1,300 questions of market participants on nearly 400 topics.

Anybody who thinks the politics of bringing back Glass-Steagall would be simpler needs to have head examined.

SEC Commissioner Paredes says "Caution Needed as New Regulatory Regime Takes Shape"

Without question, there is a fundamental role for government, including the SEC, in regulating our financial markets and our economy more generally; and we need a regulatory framework that is resilient and that fits our increasingly interconnected and complex financial system. None of us welcomes the kind of hardship and turmoil that the financial crisis wrought. The key question, therefore, is not whether we will or should have regulation. The answer to that question is straightforward: we will and we should. The real question is, “How much?”

When it comes to the question of “How much?”, I am concerned that the present wave of regulation will prove to be excessive, unduly burdening and restricting our financial system and suppressing private sector innovation, entrepreneurism, and competition at the expense of our country’s economic growth and global competitiveness. My concern that we are overregulating is accentuated when instead of evaluating each rule and regulation one-by-one, the totality of the regulation that the private sector must bear is added up. As regulatory mandates mount, I worry that the cumulative impact of the aggregation of rules and regulations will make it more difficult for companies to raise capital and to manage their risks effectively; will make it more costly for individuals to borrow when they need to; will stifle the cutting-edge innovation that we depend on to drive our economy forward; will leave investors with fewer valuable opportunities for building their wealth; and will undercut job creation.

via blogs.law.harvard.edu

Please go read the whole thing, he's exactly right. And, if I may so, he's basically making the same point I made in Corporate Governance after the Financial Crisis.

SOX at 10

Yesterday was the 10th anniversary of the passage of the Sarbanes-Oxley Act. JW Verret had some timely thoughts, which I share:

There are many days that I wish Larry Ribstein were still here, and today is definitely one of those days.  He would have had a lot to say about the tenth anniversary of SOX today.  He and Henry Butler noted in their book “The Sarbanes-Oxley Debacle: What We’ve Learned; How to Fix It” that:

“while the direct costs are substantial, they are only the tip of the iceberg….An important aspect of SOX’s indirect costs is the Act’s impact on litigation. SOX gives litigators the benefit of 20/20 hindsight to identify minor or technical reporting mistakes as the basis for lawsuits against corporations, officers, and directors. While the first major market correction will be painful for investors, SOX will surely turn it into a festival for trial lawyers. Litigation on this scale should not be confused with shareholder protection. SOX has created a ticking litigation time bomb.”

Kevin Lacroix discusses a 2011 study from Cornerstone Research that demonstrated just how prescient Larry and Henry were on this aspect of SOX.  This study shows how cases involving accounting allegations are increasingly common in nearly all of the years after SOX, that cases involving internal control weakness allegations are much more likely to settle, and that cases involving accounting allegations dominate settlements as they make up 70-90% of total settlement dollars.  So it turns out, as Larry and Henry predicted, SOX has become quite the precocious child at tens-years old (which corresponds, I am told, with fourth grade). ...

I miss Larry too, precisely because he was very nearly unrivaled in his ability to get to the heart of the problems with laws like SOX.

In any case, if you are one of those who still struggle daily with SOX's complexities, may I suggest my book Complete Guide to Sarbanes-Oxley?

The LIBOR Scandal and the prospect for bad law

It is a fundamental claim of my book Corporate Governance after the Financial Crisis that financial bubbles almost invariably lead to bad law. As I summarize the argument in the introduction to the text:

The basic thesis of this work is that the federal government—especially Congress—normally pays little attention to corporate governance. Only in response to major economic crises does corporate governance become a matter of national political concern. This recurrent pattern inherently tends to result in flawed legislation. This is so because, in the first instance, federal corporate governance regulation tends to be enacted in a post-crisis climate of intense political pressure, which discourages taking the time necessary to conduct careful analysis of costs and benefits. Second, federal corporate governance regulation tends to be driven by populist anti-corporate emotions. Finally, the content of federal corporate governance regulation is often derived from prepackaged proposals advocated by policy entrepreneurs skeptical of corporations and markets. Their agenda therefore is often at odds with the interests of Main Street corporations and their retail investors.

Worse yet, as I demonstrate in the concluding chapter of Corporate Governance after the Financial Crisis, such laws almost never get repealed:

… the uniformity imposed by federal law precludes experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Likewise, the persistent refusal to accommodate private ordering eliminates solutions from emerging from competition in the market. Instead, the federalization of corporate governance has resulted in rules that were wrong from the outset or may quickly become obsolete, but are effectively carved into stone with little prospect for change.

In sum, the federal role in corporate governance appears to be a case of what Robert Higgs identified as the ratchet effect.  Higgs demonstrated that wars and other major crises typically trigger a dramatic growth in the size of government, accompanied by higher taxes, greater regulation, and loss of civil liberties. Once the crisis ends, government may shrink somewhat in size and power, but rarely back to pre-crisis levels. Just as a ratchet wrench works only in one direction, the size and scope of government tends to move in only one direction—upwards—because the interest groups that favored the changes now have an incentive to preserve the new status quo, as do the bureaucrats who gained new powers and prestige. Hence, each crisis has the effect of ratcheting up the long-term size and scope of government.

Financial scandals rarely have a potent a regulatory effect as bubbles. If a scandal gets big enough, however, it too can lead to bad laws and twist the ratchet yet higher.

I'm worried that the brewing LIBOR scandal will prove big enough to generate bubble law-like bad law.

There's no doubt that employees of major banks (possibly in cahoots with their regulators) engaged in some serious misconduct. As The Economist explains:

The attempts to rig LIBOR (the London inter-bank offered rate), a benchmark interest rate, not only betray a culture of casual dishonesty; they set the stage for lawsuits and more regulation right the way round the globe. This could well be global finance’s “tobacco moment”. ...

The evidence that has emerged from the Barclays investigation reveals two types of bad behaviour. The first was designed to manipulate LIBOR to bolster traders’ profits. Barclays traders pushed their own money-market desks to doctor submissions for LIBOR (and for EURIBOR, a euro-based interest rate put together in Brussels). They were also colluding with counterparts at other banks, making and receiving requests to pass on to their respective submitters. ...

The second type of LIBOR-rigging, which started in 2007 with the onset of the credit crunch, could also lead to litigation, but is ethically more complicated, because there was a “public good” of sorts involved. During the crisis, a high LIBOR submission was widely seen as a sign of financial weakness. Barclays lowered its submissions so that it could drop back into the pack of panel banks; it has released evidence that can be interpreted as an implicit nod from the Bank of England (and Whitehall mandarins) to do so. The central bank denies this, but at the time governments were rightly desperate to bolster confidence in banks and keep credit flowing. The suspicion is that at least some banks were submitting low LIBOR estimates with tacit permission from their regulators.

Even though I suspect most commentators could not tell you what LIBOR stands for, let alone what it is, how it is set, or what it's used for, calls are already echoing around the 24-hours news cycle for massive new regulation. The BBC reports that Bank of England chief Mervyn King, to cite but one scary example, "a total separation between" retail and investment banking. In other words, he wants a UK version of the USA's old Glass-Steagall Act. Indeed, The Financial Times reports that calls for just such a new law are sounding widely in the UK:

The revelation that swaps traders at Barclays manipulated Libor lending rates has induced convulsions in Westminster and the media. ... Lombard suggested a couple of weeks ago that rate-rigging would reinvigorate calls for a Glass-Steagall style break-up of universal banks. So it has proved. Barclays is rightly seen as emblematic of the capture of a solid old bank by amoral risk-takers. Swap traders exploited their access to Treasury staff within the model of a universal bank to manipulate its Libor submissions.

The 1999 repeal of Glass-Steagall was one of the rare occasions when the ratchet slipped in favor of deregulation. Repeal was an essential response to the inefficiencies inherent in the artificial separation of commercial and investment banking, which by the 1990s had resulted in the former facing declining business opportunities, intense competition, and falling profits. The complex nuances of deciding where the line between commercial and investment banking lay resulted in massive rent seeking and even cases of corruption.

All this despite, the lack of evidence that the pre-Glass-Steagall structure of the banking industry was responsible for the financial crisis of 1929 and thereafter. To the contrary, as Jonathan Macey observed in 2000 (25 JCORPL 691):

… there is a wealth of historical and empirical evidence showing that bank involvement in the securities business makes financial institutions and the economy safer. In particular, a careful study by Eugene White found that securities activities of commercial banks prior to Glass-Steagall did not impair bank stability. Banks in the securities industry were not riskier (as measured by earnings variance) and did not have lower capital than banks without any securities operations.

More importantly, banks involved in the securities business were less likely to fail than banks that were not involved in the securities business. Five thousand banks failed in the 1920s, but virtually none of these were the city banks that had securities affiliates. Moreover, in the bank failures at the height of the Great Depression (between 1930 and 1933), although more than twenty-five percent of all national banks failed, less than ten percent of the national banks with large securities operations closed. 

Even so, pro-big government/anti-bank regulators and activists have been trying to bring it back ever since. But Glass-Steagall was such an awful idea that even Chris Dodd and Barney Frank gave it a miss in Dodd-Frank. Unfortunately, the LIBOR scandal could be the final impetus the pro-regulatory types need.

Just as there is no evidence that allowing commercial and investment banking to co-exist within the same firm was causally linked to the bank failures of the 1930s, there is no evidence--zero, nada, zilch--that it contributed to the LIBOR scandal.

The LIBOR scandal was caused by roque employees and complicit regulators (the latter being a fact that ought to give even liberal fans of big government pause). It is a form of price-fixing. As such, no one has yet identified any misconduct that is not already illegal under existing laws.

The answer thus is not to bring back Glass-Steagall.

The answer is to enforce the laws that are already on the books.

And, while we're at it, to ask USA and UK regulators how they--once again (see, e.g., Bernie Madoff)-- managed to miss a huge criminal enterprise taking place right under their noses.

Update: Over at OTB (thanks for the link), one of James Joyner's commentators opined:

Citing a study made in 2000 suggests that it may need to be updated based upon the events of the last few years. A study showing that the “securities activities of commercial banks … did not impair bank stability” in the 2008 crash may be more useful.

Fair enough. How about:

"After reviewing the Glass-Steagall Act of 1933 and related subsequent developments, this paper discusses the enactment of GLBA and demonstrates that the GLBA and little or nothing to do with the crisis and thus that a re-enactment of the Glass-Steagall barriers or enactment of the Volcker Rule would not prevent future such barriers. The paper argues that the GLBA’s erection of a new barrier to a non-financial firm’s ownership of a depository institution was misguided. Thus, in an important sense, the GLBA did not go far enough in breaking down barriers." -- White, Lawrence J., The Gramm-Leach-Bliley Act of 1999: A Bridge Too Far? Or Not Far Enough? (2010). Suffolk University Law Review, 2010. Available at SSRN: http://ssrn.com/abstract=1836668

Or this one: "Several factors have been blamed for the recent financial crisis and while banks have been centred in the main causes of it , the separation of investment and commercial banking activities does not seem to be the solution .... In fact, the re-introduction of the Glass-Steagall Act of 1993; could be quite damaging to the global economy due to major advancements in technology and the advent of globalisation, since 1933 .... This paper analyses information on the Glass-Steagall Act in terms of how it came about and how it would impact the global economy today. Taking the above mentioned developments into account as well as the growing evidence that banks need to be too big to fail in order to survive; this paper concludes that, investment and commercial banking activities should not be separated. Instead, adequate regulation should be in place to safeguard banks from failing." Obiri, Cynthia, Commercial and Investment Banking Activities: Combined? (May 16, 2012). Available at SSRN: http://ssrn.com/abstract=2061821

Yet more on money market mutual fund reform

An email from law professor David Groshoff:

I'm responding to several of ProfessorBainbridge.com's recent posts regarding proposed reforms for money market mutual funds, partly contextualized by last week's SCOTUS opinion regarding insurance mandates and markets.  I included Professor Davidoff on this e-mail, not only because he was the referenced author of one of those posts but also because I'm a Moritz alumnus who's always pleased to read our faculty's thoughts in thought-provoking outlets. 
  
I'm uncertain if you were aware [you probably were, but just in case] that the ICI has maintained an affiliated insurance group, ICI Mutual, for quite some time.  During part of that time ICI Mutual insured a meaningful number of money market funds against the risk of a fund's NAV proverbially "breaking the buck."  Off the top of my head, this insurance existed until somewhere around 2003(ish?), when government-generated artificially low interest rates went from being a short-term phenomenon to an intermediate/longer-term drain. 

Generally speaking, my recollection is that the default/break-the-buck insurance was in the form of an annual policy, with the cost of this insurance ranging from a few basis points for quickly fallen angel issuers [such as utilities during the Enron rolling blackout era] to progressively higher amounts for money market paper whose issuers found themselves on NRSRO ratings downgrade watches/outlooks or that began with non-perfect NRSRO ratings at the time of issuance. A number of interesting features existed in the policies that exceed the scope of this (already lengthy) e-mail.

Regardless, when we return to a more traditional interest rate environment where: (i) an insurance provider could charge a few (any?) basis points to funds to cover the cost of providing such insurance (ii) investors could still reap a near-market-rate of return for investing in "insured" short-term paper, and (iii) sufficient investment management fees could occur for the Money Market funds' RIAs/RICs, then perhaps money market insurance could again present itself as a better alternative to explore relative to additional layers of the currently discussed regulation.  

Any suggestion of mine for an individual mandate on money market providers to purchase "break-the-buck-insurance" is strictly tongue-in-cheek.  Having said that, however, perhaps an organically generated competitive insurance model in which multiple insurers potentially arise to diversify short-term paper default risk within money market funds in a competitive insurance landscape may be workable in a more traditional environment when rates return to where they'd more likely tend to be without Fed and other pressures maintaining current artificially low rates.

Davidoff replies re money market funds

Steven Davidoff sent along this reply to my post about why a floating NAV for money market funds is a bad idea:

I take your point that pricing according to NAV will create both tax and accounting problems.  But I wasn’t advocating for that as a solution (it may very well be the one, but that is another discussion and you make an excellent point against).  What I was saying is that right now money market funds are designed to run perfectly and never fail, yet they are inherently unstable akin to banks.  I believe this makes issuers less likely to rely on them for funding and depositors less likely to use them. Now, the solution to this problem is to make the system more stable.  This could take the form of an NAV pricing requirement, but it could also be a capital requirement, or it could be another proposal like Jeff Gordon’s dual class shares proposal which seems to solve much of the tax and accounting problems. I’m sure that you could also come up with something if you put your mind to it. While nothing is very certain finance seems to be rather good at finding creative solutions to problems, and I am not sure why this shouldn’t be the case here, but perhaps I am too optimistic.  In any event, the ultimate point is that the inherent instability of these funds is a remaining problem that should be addressed before another fund inevitably breaks the buck, and that in the meantime the industry is only hurting itself.

Money market reform and taxes

Steven Davidoff is dismissive of money market mutual fund industry complaints that proposed reforms would "require complex accounting and tax record-keeping by investors." Speaking personally, given the minuscule returns money market funds are paying these days, I probably would stop using them and just leave my rainy day savings/cash flow management funds in my checking account rather than trying to deal with headaches come tax time of having a constantly fluctuating NAV. Who wants to deal with paying taxes on, say, 10 cents worth of capital gains because you sold 1000 shares at $1.00 and had a basis in those shares of $0.9999? And what if you want to use actual cost basis instead of average cost basis? Maybe it'd be worth doing if you're a billion dollar institution, but my guess is that a floating NAV would drive retail investors out of the money market industry.

The adverse tax and accounting consequences, as well as the capital market consequences of driving retail investors out of the commercial paper market, seem an awfully high price to pay because Congress is to fraking chicken to tell voters that it won't bail out mutual funds that go bust.

Update: I am currently invested in a California tax-exempt money market paying a whopping 0.02% average annual rate of return. That probably doesn't even cover the opportunity costs of transferring money to it from checking. How high a return would the fund have to pay to justify the costs (both real and opportunity) associated with a floating NAV? At least enough to pay for a TurboTax program!

Challenge to key Dodd-Frank financial services provisions

The Competitive Enterprise Institute (CEI) has announced that:

The State National Bank of Big Spring, Texas, today filed a lawsuit asking the U.S. District Court for the District of Columbia to hear its case challenging the constitutionality of provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Competitive Enterprise Institute and the 60 Plus Association are also joining this community bank as plaintiffs in the same action, requesting the Court to invalidate the law because of the unprecedented, unchecked power it gives the government. ...

According to the complaint, there are no effective checks and balances to assure the public of accountability.  Most importantly:

• Congress exercises no “power of the purse” over the CFPB, because the agency’s budget – administered essentially by one person – comes from the Federal Reserve, amounting to approximately $400 million that Congress cannot touch or regulate.
• The President cannot carry out his constitutional obligation to “take care that the laws be faithfully executed,” because the President cannot remove the CFPB Director except under limited circumstances.
• Judicial review of the CFPB’s actions is limited, because Dodd-Frank requires the courts to give extra deference to the CFPB’s legal interpretations.
• The plaintiffs claim in their suit that Dodd-Frank gives an agency of unelected government bureaucrats unrestrained power. They argue this unaccountable power over the daily lives of the American people results in a lack of public accountability, creating a power grab over every U.S. citizen.

“As a whole, Dodd-Frank aggregates the power of all three branches of government in one unelected, unsupervised and unaccountable bureaucrat,” said former White House Counsel C. Boyden Gray, attorney for the plaintiffs and founder of Boyden Gray & Associates. ...

The complaint is here. The Federalist Society has put together a web page with links to lots of key documents, including an essay by Boyden Gray that formed the foundation for the law suit. Gray also co-authored a WSJ op-ed on the lawsuit.

These are many of the same guys the guys that won the suit claiming that the PCAOB's lack of accountability to executive branch violated the Constitution. As far as I can tell from a quick glance, their arguments here seem even stronger. The Democrats who wrote Dodd-Frank were determined to insulate these agencies from oversight, presumably out of fear that future GOP Presidents and/or Congresses might actually want to constrain the agencies' powers. But our Constitution doesn't work that way.

Is Venture Capital in Crisis?

The recent financial crisis cannot totally be blamed for the marked drops in venture capital fundraising, reduced venture investment and the hindrance of successful exits around the world, but it may have exacerbated the existing problems. Poor returns over the past decade indicate most fund managers do not earn their fees, and investors have been increasingly wary of taking on added risk without getting the reward. Structural changes are inevitable to the venture capital marketplace to preserve an essential source of funding for nascent high-growth companies.

--Cumming, Douglas J. and Johan, Sofia A., Is Venture Capital in Crisis? (June 11, 2012). World Economic Review, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2082062

via papers.ssrn.com

Question of the day

Assuming the looming global economic slow down leads into a Eurozone crisis that causes a meltdown of at least 2007-2008 proportions, will the people who foisted Dodd-Frank on us admit that Congress doesn't know what it is doing, has been unable to "fix" the markets, probably just make things wrose when they legislate, and admit that they should just leave it up to the markets to sort these things out? Or will they frak out and pass even more burdensome, costly, ineffectual, and economy-stifling legislation?

BTW, Sarbanes-Oxley was just about 60 pages long. Dodd-Frank was around 850 pages. My math skills are too rusty to figure out how many pages that projects a Eurozone crisis bill would require and I know you can't make straight line progressions from an n of 2, but even so the mind boggles.

Jonathan Macey: Losing Money Isn't a Crime

The trades that J.P. Morgan made were extremely complex, and it certainly appears that they did not work the way that they were supposed to. But the reason that markets work better than central planning is because market participants learn from experience, and they learn fast and thoroughly because they suffer significant losses when their investments, whether they be hedges or not, turn out badly.

Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan's losses should be treated as further proof that markets work. J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.

The second lesson from J.P. Morgan's failed hedging effort is that politicians and regulators are opportunists who will use any pretext to increase their power and influence. Rahm Emanuel, the former chief of staff to President Obama, once famously said that one should never let a crisis to go to waste. It appears that the current regulatory class is of the view that even crises that are not serious must be exploited.

via online.wsj.com

Please go read the whole thing.

Putting the JP Morgan loss in perspective

Left-liberal propaganda sheets like the NY Times and ThinkProgress are using the $2 billion loss JP Morgan suffered on a failed hedge to justify doubling down on the Volcker Rule, despite the demonstrable fact that The Volcker Rule is a regulatory nightmare that isn't going to work.

Let's put that $2 billion loss in context. JP Morgan had first-quarter 2012 net income of $5.4 billion on revenues of $27.4 billion. Morgan thus is still in the black so far this year, despite this hit.

The $2 billion figure is a headline-grabber, but it posed no threat to JP Morgan's viability, let alone a systemic threat. Using it to justify more restrictive regulation is thus mere agitprop.

Meanwhile, the US National Debt has continued to increase an average of $3.95 billion per day since September 28, 2007. In other words, the federal government is losing twice as much per day as JP Morgan lost in this quarter. Maybe we ought to be regulating the feds not the banks.

Matt Yglesias accuses JP Morgan of ducking nonexistent rule. Why?

Matthew Yglesias rails against JP Morgan for having had an investment go south:

Remember the "Volcker Rule" that was supposed to stop systemically significant financial institutions from wracking up huge losses on proprietary speculative bets? Well earlier this evening JP Morgan CEO Jamie Dimon announced that his company just lost $2 billion on some of (French-born) "London Whale" Bruno Iksil's bets on credit default swap indexes.

Dimon repeatedly insisted that the whole operation is Volcker-compliant, and JP Morgan is describing the operation as an effort at hedging gone wrong. Nobody knows exactly what happened, but in general if you just lost $2 billion that's a good sign that you're not hedging. The idea of hedging is to accept a small cost in order to insure yourself against the risk of a big loss. Two billion dollars is a big loss even for JP Morgan. So why call it hedging? Presumably because the Volcker Rule allows proprietary trading for the purposes of hedging. This turns out to be a big loophole.

Minor problem: There is no Volcker rule. To be sure, Dodd-Frank ordered regulators to come up with one, but to date they have failed to promulgate a final rule.

Update: The original title for this post was "Matt Yglesias accuses JP Morgan of violating nonexistent rule."

Yglesias objected thereto, sending along the following email:

Excuse me, but my post simply does not accuse JP Morgan of violating the Volcker Rule. If anything, it does the reverse—it accuses the rule of not banning what JP Morgan did even though you would have to ban what JP Morgan did to achieve the policy aims that were supposed to animate it. 

Fair enough. So I changed the title. My point remains, however, that there is NO Volcker rule. The regulatory agencies are still trying to finalize one. So why would Yglesias accuse Morgan of having ducked a non-existent rule?

My suspicion thus is that pundits like Yglesias are now going to seize on JP Morgan's bad bet to push for last minute changes that will make the rule--if and when adopted--even more restrictive. Indeed, as Bloomberg reports, Jamie Dimon sees it coming:

“It is very unfortunate,” he said, “this plays right into the hands of pundits out there. But we have to deal with it.”

Argument by anecdote is a useful rhetorical tactic, but lousy evidence. JP Morgan made a bad bet, but it is hardly one that threatens the health of the firm, let alone the economy. Indeed, Yglesias concedes as much:

As it happens in this case JP Morgan has a big enough capital buffer to eat the loss and they only lost $2 billion rather than $20 billion. 

But that bad bet is going to be seized upon by Yglesias and/or his ilk to justify an even more expansive version of what I firmly believe is a regulatory nightmare that isn't going to work. Indeed, immediately after acknowledging that Morgan can "eat the loss," Yglesias goes on to say:

But nothing was stopping them from screwing up even worse.

The reader is left to infer that something ought to be there to stop Morgan. Namely, a tougher Volcker rule without this alleged "loophole."

The Volcker Rule is a regulatory nightmare that isn't going to work

In Dodd-Frank, Congress mandated that the SEC and other financial regulators develop a version of the so-called Volcker rule.

The Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that do not benefit their customers. Volcker argued that such speculative activity played a key role in the financial crisis of 2007–2010. The rule is often referred to as a ban on proprietary trading by commercial banks, whereby deposits are used to trade on the bank's personal accounts, although a number of exceptions to this ban were included in the Dodd-Frank law. The rule's provisions are scheduled to be implemented as a part of Dodd-Frank on July 21, 2012.

I'm doubtful that the agencies will make that deadline. But I'm even more doubtful that this looming regulatory disaster will work.

One problem is that the "ban" will be riddled with many exemptions, permitting massive amounts of proprietary trading. For example, there's a new push to exempt venture capital financing from the Volcker Rule:

In a letter to the SEC, Representative Bob Goodlatte (R-VA) urged that the final regulations implementing the Dodd-Frank Volcker Rule provisions exempt venture capital funds or provide that they are a permitted activity under Section (d)(I)(J). ... Venture capital investing helps startup companies around the country create jobs, build products, invest in research and development and generate life-changing solutions in fields like energy and life sciences, he posited. Further, the venture ecosystem is one of the bright spots in the U.S. economy. In 2010, venture-backed companies employed 11.9 million people and generated $3.1 trillion in revenues. Therefore, the legislator emphasized that it is vital that the final regulations do not create an unnecessary barrier to future venture investing, especially because it does not carry the risks the Volcker Rule aimed to limit.

There will be many more of these sort of exemptions in the final rule. What will follow is likely to be years of regulatory rule making and litigation over whether certain activities qualify for one of those exemptions. The so-called ban likely will suffer the slow death of a thousand cuts.

On top of which, there will be years of work entailed in dealing with all the unitended consequences and unanticipated problems that are inevitable in such a complex regulatory scheme. Consider, for example, the new complaint that the Volcker Rule violates NAFTA:

The Volcker Rule may contravene the NAFT A trade agreement, said the Canadian investment industry, since it will clearly interfere with and raise the costs of cross-border dealing in Canadian securities. In a letter to the SEC and other federal financial regulators crafting regulations implementing the Dodd-Frank Volcker Rule provisions, the Investment Industry Association of Canada said that the Volcker Rule also runs counter to G20 and Financial Stability Board objectives for coordinated policymaking across jurisdictions. The association urged the SEC to extend the proposed exemption from the proprietary trading prohibitions for U.S. Treasury bonds and U.S. state and municipal bonds to foreign government securities, particularly to the securities of Canadian federal and provincial governments.

Inevitably, people are going to find more and more of these sort of conflicts between the Volcker Rule and other laws, especially but not only in the context of the Rule's extra-territorial effects.

I was prepared to support the original Volcker rule as an imperfect solution to the moral hazard inherently created by deposit insurance. 

Unfortunately, the process of turning the simple original proposal into law has turned into a classic example of legislative and regulatory sausage making. The end product is shaping up to be an unpalatable mess.

Update: My friend Kim Krawiec writes about this post that:

A recent post by my friend Steve Bainbridge reminds me that I’ve been meaning to weigh in on the most recent in a long line of controversies surrounding the Volcker rule ....

I’m largely on board with Steve’s general analysis of the rule, but I want to push back against his contention that regulators have taken Congress’s simple ban and turned it into an unworkable monstrosity at the behest of relentless industry lobbying.  This charge has been taken up by a number of sources lately (see here and here), including by some self-serving members of Congress.

Let’s get one thing straight: Congress did not enact a simple rule – it enacted a short rule.  By definition, a rule that purports to ban proprietary trading while maintaining an active role for banks as financial market intermediaries, including as market makers, is not a simple rule. 

If this post in fact implies that "regulators have taken Congress’s simple ban and turned it into an unworkable monstrosity," it was not my intent to have you readers draw that inference. (1) My reference to the "original Volcker rule" linked back to a post discussing Paul Volcker's original suggestion, not the version incorporated into Dodd-Frank. (2) I noted that "the process of turning the simple original proposal into law has turned into a classic example of legislative and regulatory sausage making." I thus had no intention of complimenting Congress for its work in Dodd-Frank. To the contrary, I intended to suggest that both Congress and the regulators were at fault. Indeed, I've agreed all along with Kim's observation that the regulatory mess was "predictable, indeed virtually inevitable, given the original statute." Of course, having said that, the regulators have not distinguished themselves in the process of turning the flawed statute into regulatory specifics.

Podcast interview re Corporate Governance After the Financial Crisis

Collected Miscellany: 

For this week’s edition of Coffee and Markets, Pejman Yousefzadeh and I were joined by Stephen Bainbridge.  We discussed his book, Corporate Governance After the Financial Crisis, the general shortcomings of policy approaches to financial crises, and the shortcomings of Sarbanes-Oxley, and Dodd-Frank in particular.

Listen here.

My thanks to the hosts for this wonderful opportunity.