WASHINGTON – A half-decade after the first indications of the global economic crisis were spotted in the U.S. financial sector, regulators from an unprecedented slew of federal oversight agencies are facing a White House deadline to finalize a key rule that supporters say would do much to close a significant vulnerability in the country’s economy.
Known colloquially as the Volcker rule, the regulation would ban traditional banks, those that hold depositors’ accounts, from parenting with hedge funds or from engaging in risky, short-term trading with their customers’ money. In recent years, this so-called proprietary trading has come to be seen as a central factor leading to the 2007-08 financial collapse.
In fact, the Volcker rule is already federal law, passed as part of the massive financial sector overall bill known as the Dodd-Frank Act, signed in 2010. But since that time, five separate regulatory agencies, including those that focus on the markets and others on the banks, have been working to come up with a rule that will satisfy all parties.
They’ve already blown by multiple deadlines, and an early proposal was criticized by many outside of the industry as being both too weak and too complex. Yet in recent weeks, leaks from the process have suggested that a stronger version of the Volcker rule could now be in the offing, and both President Obama and Treasury Secretary Jacob Lew have stepped up lobbying efforts to push for a final rule before the end of the year.
“There are two major reasons for the lateness of this rule. First, of course, the financial sector hates it, so resistance has been fierce. The financial industry has tremendous resources and leverage, and has been trying to weaken, slow and do anything else it can to limit this rule,” Wallace Turbeville, a former investment banker and now a senior fellow with Demos, a public policy think tank, told Mint.
“Second, the rule has to be passed by five agencies at once. I’m not sure whether that has ever happened before, particularly on something this big and controversial.”
Secretary Lew last week said he was now “optimistic” that the final details of the 1,000-page rule would be finished by the end of the year. He also suggested that the financial industry has started to accept that additional reforms, including new limits on proprietary trading, are now a certainty.
“I think that if you look at the period of time from Dodd-Frank being enacted to now, there were a couple of years where every effort to delay implementation of Dodd-Frank was used,” Lew told a panel discussion last week. “For the last year we’ve seen a different environment, an environment where the need for certainty and acceptance that Dodd-Frank is the law of the land seems to have replaced that effort to delay and perhaps repeal it.”
At least publically, however, such a change of heart appears far from certain. The American Bankers Association, an important lobby group, pointed Mint to a year-old list of concerns over the Volcker-related rulemaking, noting that “It is important that the final rules not impair the availability of traditional banking services to bank customers, nor impose unnecessary costs on banks where there is no systemic risk or threat to the U.S. financial system.”
And on Tuesday the U.S. Chamber of Commerce, the country’s largest industry lobby group, wrote to regulators to urge them to put off the deadline once again. Citing recent changes made to the rule since the last public comment period closed, in February 2012, a Chamber official warned that “The process to date has created a ‘black box’ of rule writing that could result in an unbridled exercise of regulatory power that can harm the economy.”
Separating risk and insurance
Limits on commercial banks’ ability to engage in risky investments with depositors’ money were actually in place for decades, signed into law shortly after the stock market crash of 1929. Under legislation known as the Glass-Steagall Act, signed during the early 1930s and extended in the 1950s, the federal government made two primary moves: it required the separation of deposit-taking and investment banks, and created a new government insurance program for bank accounts – the Federal Deposit Insurance Corporation (FDIC), one of the agencies currently writing the Volcker rule details.
The first part of this new regulatory regime was meant to reduce the risks that banks were taking with depositors’ money, while aimed at stopping the “bank runs” that had imperiled banks during the late 19th and early 20th centuries. Critically, the two approaches worked in parallel: while investment banks would be allowed to continue to engage in greater financial risks, that money would be completely cut off from the potential for a government bailout.
While this system worked well for decades, by the 1970s large banks were increasingly lobbying Congress and the various regulatory agencies for greater flexibility in the types of investing they were allowed to do. Congress and the courts repeatedly denied these requests, as did the chairman of the Federal Reserve during the 1980s, Paul Volcker.
When he stepped aside later that decade, however, he handed over power to Alan Greenspan, widely known for his anti-regulatory beliefs and now seen as one of the key officials to usher in the risk-taking that led to the 2007-08 financial crisis. Greenspan, together with officials in the administration of President Bill Clinton (including the president himself), steadily chipped away at the Glass-Steagall Act, arguing that it was too outdated for the ways of the modern economy. Congress effectively repealed it in 1999.
The Volcker rule is named for the former Fed chairman, who shortly after the financial crisis began suggesting the creation of a new firewall between investment banking and FDIC-backed depositor accounts. Today, the rule is thought of as an updated version of the Glass-Steagall Act, part of a broader attempt to place new controls on the amount of risk that commercial banks can take.
“The Volcker rule is really a critical part of the whole reform package, but it’s different from the rest of the Dodd-Frank reforms in that it addresses banks that are insured by the federal government and other institutions that are considered ‘systemically important,’ and prohibits them from trading on their own credit in ways that are for short-term profit,” Turbeville said.
“That’s categorically different from the rest of Dodd-Frank, in that it is limiting activities rather than measuring risk, setting aside money or regulating how the markets work.”
Getting a strong version the Volcker rule in place would be a significant achievement for multiple reasons, with the first being the rule’s centrality in the overall U.S. regulatory response to the 2007-08 financial crisis. Second, a successful rulemaking process would provide a precedent for the five agencies engaged, showing that it is possible for them to work together and communicate more directly – long a key demand by proponents of stronger financial regulation.
Third, many observers have expressed concern that the longer a big, complex rule like this lingers in the planning stage, the likelihood of its eventual implementation weakens. If key stakeholders continue to press for additional negotiation, for instance, the regulatory agencies may eventually feel the need to start over with a new Volcker rule proposal entirely.
There is also a political consideration around this particular rule. Public confidence in the Obama administration’s competence has been repeatedly shaken in recent months, and a strong Volcker rule would be seen in policy circles as important proof that the administration can achieve results on complex undertakings. Such concerns are undoubtedly part of the calculus behind the new pressure from the president and Treasury secretary.
Responding to old problems
Worryingly, however, neither success on getting the Volcker rule in place, nor the slow but steady progress being made on the other 200-some regulatory rules associated with Dodd-Frank, mean that the U.S. financial system is necessarily stronger than it was before the financial crisis, or that it would be more resilient in the face of another such crisis.
Indeed, long-time observers such as Turbeville point out that the United States’ regulatory regime is only now starting to catch up with where the country stood a half-decade ago.
“The fact is, conditions are worse than they were in 2007-08. We have far more concentration in the market today, in part because several firms were lost or absorbed,” he said.
“By and large, Dodd-Frank was responsive to the [international discussions] that occurred in 2009, which broadly talked about principles. Today we know much more than we knew in 2009 or 2010, but whether we can translate that knowledge base under the normal political process or whether that will require another crisis is an open question.”
Several bills under discussion on Capitol Hill would address various facets of strengthening U.S. financial resilience. Yet the torchbearer for the push to address this continued market concentration – the “too big to fail” conundrum – is the newly elected senator from Massachusetts, Elizabeth Warren.
“Today, the four biggest banks are 30 percent larger than they were five years ago, and the five largest banks now hold more than half of the total banking assets in the country,” Warren said in an address here in Washington earlier this month. “One study earlier this year showed that the ‘too big to fail’ status is giving the 10 biggest US banks an annual taxpayer subsidy of $83 billion.”
Warren recently proposed legislation called the 21st Century Glass-Steagall Act, which she said would “restore the stability to the financial system that began to disappear in the 1980s and 1990s.” She also warned that if regulators were unable to act in a timely fashion on this issue, the responsibility would fall back to Congress. Treasury Secretary Lew recently made a similar pronouncement, stating that if the ‘too big to fail’ problem was still an issue by the end of the year, other approaches would be required.
And even as federal regulators focus much of their efforts on reducing risks to the traditional deposit banks that receive government backing, others are pointing to much broader systemic risk that oversight agencies have barely begun to address. This has to do with the constellation of entities, outside of the traditional banks, that have increasingly come to rest at the center of the U.S. financial system: the investments banks, money-market funds, hedge funds, mortgage companies, various types of insurers and others that collectively make up what’s known as the “shadow banking” industry.
At the end of 2011, this highly opaque, highly differentiated sector was estimated to be worth some $60 trillion, about half of the total U.S. banking industry. And while many of these entities exist largely outside of U.S. regulatory reach, these industries have become intricately intertwined with the big traditional banks, particularly as a way of raising short-term money. Many fear that poor federal oversight of the “shadow banks” has thus left a gaping hole in the regulation of the entire financial sector, including those parts backed by federal guarantees.
“Not that the banks don’t deserve it, but they’ve really become quite the target of populist outrage as well as some of the reform efforts [in Washington],” Sheila Bair, the former chair of the FDIC, said Friday at an address here.
“But one of the lessons of the crisis is that you can’t just focus on institutions that are subject to the regulatory penumbra and think that you’re effectively dealing with systemic risk. The 2008 financial crisis has been called a run on the shadow banking system, and that’s pretty much what it was,” Blair said.
Yet while the Dodd-Frank Act did start to fashion tool with which to start to regulate the shadow banks – particularly in the oversight of derivatives – and gauge broader systemic risk, Bair and others are warning that the necessary work has barely begun. Whether regulators or legislators will be able to act effectively without the pressure of another foundation-shaking economic crisis, however, remains to be seen.