Tuesday, February 14, 2012

The Volcker Rule -- Another Bad Idea

The Volcker Rule -- the idea of banning proprietary trading by investment banks -- is a terrible idea. This rule is designed as a response to the 2007-09 financial crisis. But, proprietary trading made no contributions to the financial crisis. This is simply one more punitive attack on Wall Street with unfortunate side effects for average Americans.

The problem is that in order to ban proprietary trading, you must define what you mean by market making and therein lies the problem. Market making is faciliting the purchases and sales of investors. The Volcker Rule requires no trade unless the other side of the transaction can be found. The bank itself is not permitted, under the Volcker Rule, to participate in any way on its own account to facilitate the transaction.

This is ridiculous.

The impact would be increased volatility and terrible transaction outcomes for traders and investors.

This reduced liquidity will adversely affect everyone.

Volcker's response: liquidity is a bad thing. Liquidity creates asset pricing bubbles.

Volcker's response shows that he really doesn't understand capital markets as well as he thinks he does. There has been a massive amount of research on liquidity and as yet no one has advanced the argument that liquidity creates asset bubbles. In fact, most research on this topic suggests exactly the opposite.

Andrew Sorkin reports in today's NY Times that JPMorgan's highly respected CEO (and Obama supporter) Jamie Dimon had this to say of Volcker: "Paul Volcker by his own admission has said he doesn't understand capital markets. He has proven that to me."

The country owes a great debt to Volcker for his management of the Federal Reserve in the early 1980s, but the "Volcker Rule" is a discredit to his legacy.

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