Dodd-Frank V: Glass-Steagall and the Disappearing Volcker Rule

In January 2010, in the wake of a stinging Democratic defeat in the Massachusetts election to fill Senator Ted Kennedy's seat, President Obama embraced the so-called Volcker Rule to split proprietary trading and hedge fund investments from banking. As John Cassidy highlights the rule rested on a simple premise: given the special safety nets that banks enjoy (deposit insurance and emergency lending) it makes little sense to subsidize securities and trading speculation. The Volcker Rule could well operate to diminish the size of the megabanks, as the Glass-Steagall Act did in the wake of the Great Depression, ushering in more than 70 years of unprecedented financial stability. Unfortunately, Dodd-Frank waters down the Volcker Rule and essentially leaves the megabanks intact for years to come.

The first problem with the Volcker Rule is that gives the banks years to comply, in some cases more than a dozen years. Instead of any divestiture mandate, the banks may seek multiple extensions. Under section 619, for example, the Fed may permit bank investments in illiquid hedge funds or private equity funds until 2022. Liquid funds may be held until 2017. Indeed, nothing changes at all until October of 2012 and no divestitures are required until October of 2014. While some transition time may be warranted a spin-off to shareholders or public investors could certainly occur within a year. In any event, bank capital will continue to be exposed to securities trading and hedge funds for years to come notwithstanding the so-called Volcker Rule.

The second problem is the exceptions to the trading and hedge fund ban under section 619. Hedging, underwriting and market making activities are permissible. Banks may still continue to organize and offer hedge funds and private equity funds. They may still devote up to 3% of their capital to trading and hedge fund investments. The regulators may further permit trading and investments that "promote the safety and soundness of the banking entity and financial stability of the United States." These exceptions may well operate to swallow the rule when it takes effect in coming years and decades.

Even Paul Volcker himself is uneasy with this final outcome. Personally, I think its worse. This rule will do little to protect us from excessive risks to bank capital over the short, medium, and even long term while continuing to accommodate the continued persistence of the dangerous megabanks.