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February 26, 2010

Focus on Asset Quality, Not Activities

Catherine New
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After last month’s proposal of the Volcker Rule from President Obama — an idea crafted by former Fed chairman Paul Volcker that would limit banks’ investing in speculations with subsidized capital — industry chatter likened the move to a return of the Glass-Steagall era. In the new issue of Ideas at Work, Professor David Beim examines the assumptions of the new rule and suggests a modern adaptation for the Depression-era regulation.

Volcker Rule Assumption 1: Only institutions that take insured deposits need to limit risk. Beim argues that all major financial institutions — not only the ones that take insured deposits — are liable for enormous risk. “We are now living in a world of massive moral hazard in which the government has shown it will bail out systemically important financial institutions whether they take deposits or not,” he writes. “Deposits are not the issue. We are far past that point.”

Volcker Rule Assumption 2: Banking activities must be segregated in order to prevent risk. Beim says, “It’s not the nature of the activity, but the extent of the risk.” He argues that while the rule’s goal of controlling for excessive risk is important, the focus of the rule — and of related regulatory efforts — should shift from activities to asset quality:

An effective modern adaptation of the spirit of Glass-Steagall would place substantive limits not on activities such as trading versus holding but on asset quality — what gets traded or held. Regulators are very cautious about this. It runs counter to modern regulatory thinking to impose such limits.

But some such limits may be appropriate. To adhere to Volcker’s proposal, all private equity investments and many hedge fund investments are both illiquid and themselves highly leveraged. Volcker suggests — and is correct — that such investments are not appropriate for the balance sheet of any financial institution that might have to be bailed out by the government. This idea can be pushed even further. …

Does government have the will to restrain this kind of risky lending, reversing its earlier posture? Time will tell. The current proposal, said to be reviving the spirit of Glass-Steagall, appears to have no political cost. There is no constituency for proprietary trading by banks except the discredited banks themselves. Unfortunately, as it stands, a ban on proprietary trading does little to make banks safer. Substantive restrictions on financial asset quality would go much further, giving the spirit of Glass-Steagall some modern substance.

Read the complete article in Ideas at Work.

Photo credit: Flickr/epicharmus