The Volcker Rule Distraction: There Is a Better Way to Fix "Too Big to Fail"

Since JPMorgan Chase announced a trading loss of at least $2 billion last week, reporters, analysts, and politicians have focused anew on the Wall Street Reform and Consumer Protection Act. President Obama signed this financial-regulation law, known as Dodd-Frank, into law nearly two years ago, on July 21, 2010.

In the past week, observers have placed most of their attention on Dodd Frank's Section 619: "The Volcker Rule." The Volcker Rule, when it goes into effect as early as July 2012, will prohibit banks such as JPMorgan from engaging in "proprietary trading," or speculation.

In the aftermath of the JPMorgan Chase announcement, the Volcker Rule proponents' position has been as follows. Were the Volcker Rule in place already, the rule would have prevented JPMorgan from engaging in the trading that resulted in the loss, as such trading, they say, was "proprietary." Although details are unclear, JPMorgan appears to have taken its loss in using "excess deposits" to invest in debt securities and attempt to hedge those investments. ("Excess deposits" are the difference between the amount of money a bank has taken in from depositors and the amount of money it has loaned out to borrowers.) As Sen. Carl Levin (D-MI), who helped write the Volcker Rule language, said four days after the bank's announcement, the Volcker Rule would have prohibited such activities: "If this law were in effect when they made these trades, I believe that these trades violated or were inconsistent with Dodd-Frank, yes."[1]

Yet it is far from clear that the Volcker Rule would have prevented JPMorgan from engaging in the activities that led to its loss. Among other things, the Volcker Rule allows banks to engage in securities and derivatives trading to hedge risk, as JPMorgan claims this particular activity was intended to do. Moreover, it is far from clear that preventing financial-industry losses—even losses that lead to financial-firm failure—should be the goal of financial regulation. Instead, the goal should be for financial firms to be able to fail without endangering the broader economy.

Rather than focusing on the Volcker Rule, lawmakers and regulators should turn their attention to improving other aspects of Dodd-Frank so that the law can better achieve its goals of preventing bailouts and protecting the economy from the risk posed by the financial industry.[2] These areas include treatment of derivatives instruments, treatment of capital and other requirements for "systemically important financial institutions," and treatment of failing financial firms via "orderly liquidation authority." Moreover, if lawmakers remained concerned that insured depositories such as JPMorgan should not trade in the securities markets, there is a far more straightforward way for lawmakers to accomplish that goal.

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