More on the Volcker Rule

I'm not against the Volcker Rule - I don't think it will increase risk or make things worse, but I think it's woefully insufficient at best if the goal is to curb systematic risk.  I think the goal of the proposed Volcker Rule is to allow the Administration to say to the people "Look - we hear your anger - we understand that nobody wants banking institutions involved in proprietary trading activities with government backstops."  There's nothing wrong with that - except that it will do little to nothing to prevent future crisis.

Long Term Capital Management was not a bank.  Lehman Brothers was not a bank.  Merrill Lynch was not a bank.  AIG was not a bank.  Bear Stearns was not a bank.   As I commented on Barry Ritholtz's thread on the subject: "isn’t there a very very easy way to explain why the Volcker rule is, at the very least, woefully inadequate to limit systematic risk: Lehman… Merrill… Bear Stearns… AIG… LTCM… not one of those were banks – and not one of them would have been effected/reigned in by the Volcker rule."

Barry responded that the Volcker Rule would not have prevented the current crisis, but it would be "prophylactic against the next crisis."   On the contrary - the Volcker Rule will be prophylactic against the next crisis from originating AT A BANK.   The Volcker Rule, however, does nothing to address leverage at non-bank institutions.  Now, one catch-all is that broker-dealers don't exist anymore - so now all the big players are banking institutions!  Merrill Lynch was acquired by BankAmerica, Lehman went bankrupt, Bear was acquired by JPM, and MS/GS changed their charters so that they are now "banks."  

The systematic risk to our financial world is not "banks blowing as a result of proprietary trading"- it's any financial firm blowing up because of being over-levered.  LEVERAGE is the key.    Every non-bank firm should be free to trade in such a way that allows them to lose their own money - but not to lose everyone else's money, imperil the system, and require taxpayer bailouts to quells the fallout from failure.

There is one real risk in the Volcker Rule as a populist solution, and it's this:  if the administration/regulators/powers that be think that by instituting the Volcker Rule they've quelled the public outrage over banks' proprietary trading, and they relax their guard on the real systematic risks to the system - then the rule will have done the exact opposite of what it was designed to do.

-KD