Volcker Rule – Why Wall Street Needs More Financial Regulation

   

Volcker Rule – Why Wall Street Needs More Financial Regulation

 

Wall Street is all up in arms about the so-called “Volcker Rule.” Named after its champion, former Federal Reserve Chairman Paul Volcker, this proposed rule would bring increased regulation to the financial services industry.

Volcker testified before the Senate Banking Committee Tuesday, asking them to consider the proposal, which is also backed by President Obama.

4 Banks Thrilled About Obama’s Bank Plan

This rule will attempt to split agency (handling customer orders) and propriety trading (also known as principal trading). The gist of the rule is that, if you accept deposits (as in being a bank), then you can only trade on behalf of customers. You cannot trade on behalf of your own firm’s account.

From 1933 until its repeal in 1999, the Glass-Steagall Act prevented commercial banks from conducting securities business. There was a strict separation between commercial banking and investment banking.

This law was born from the utter financial devastation that the United States experienced after the 1929 stock market crash. Like 2008, the 1929 market was fueled by cheap money and 10%-down margin loans on stocks.

When the 1929 crash hit, more than 5,000 U.S. banks went out of business, in large part because the banks had gorged themselves silly, lending money against overly inflated stocks. Separating “plain Jane” commercial banking from the far-riskier world of the securities business was an attempt by regulators to strengthen the U.S. banking system.

And you know what … it worked!

Will the ‘Volcker Rule’ Work?

We had Glass-Steagall for more than 50 years, and the markets operated just fine. Within 10 years of repealing the Glass-Steagall Act, the United States was brought to its knees.

Those guys in the 1930s knew what they were doing. They knew that the greed of the bankers would override common sense. They created the separation of commercial and investment banking to protect the country from the exact same shock that we have just gone through.

The Street is crying that the re-implementation of any rules splitting agency and principal trading will lead to illiquid markets. What they don’t say is that excess liquidity has a history of leading to excessive risk-taking. The subprime debacle was directly caused by too much cheap money chasing too little return.

Each year, there is only a finite supply of money-making opportunities available. Now, don’t get me wrong, it’s a huge number. Hundreds and hundreds of billions of dollars are made by financial institutions all over the world, every year. So, there are a lot of money-making prospects present in the financial markets, but it does have limits.

 

Will They Ever Learn?

When you have an orgy of liquidity, such as we’ve had since 1998, you have more money chasing the same finite yearly returns.

This causes institutions to create new financial opportunities that typically involve taking on more risk. This is exactly how the subprime, CDO (collateralized debt obligation) and CDS (credit-default swap) mess got started.

Banks, hedge funds and brokers were awash with hyper-cheap cash and were desperate to put it to work.

A nascent booming real estate market provided the perfect vehicle to put trillions of dollars to work at exceptional rates of returns. Almost overnight, an entirely new profit stream had been found and developed: the subprime mortgage.

‘Greed is Good’ — Until it Isn’t

Once a relatively quiet and small backwater market, the subprime space was never intended to become the recipient of so much funding. It was excess liquidity that caused the subprime bubble to inflate. It was excess liquidity that caused so-called smart and sensible bankers to make ridiculous assumptions and horrible decisions (just like they did in 1929).

Behind the facade of excess liquidity hides a myriad of potential trading minefields. Just look at AIG’s (AIG) $180 billion credit-default swap fiasco. AIG fooled itself into believing that a worst-case scenario could not happen, and the buyers of the swaps fooled themselves into believing that they were protected and, thus, took on even more risk.

It became a self-reinforcing delusion. Too much liquidity can mask horrible decision-making.

Money always has and always will flow to viable money-making opportunities. It’s only marginal markets that will suffer, and even there you’ll probably see spreads widen to properly value the risk of making a market in those less-liquid securities.

It won’t be the end of the world that Wall Street is trying to spin. The Volcker Rule attempts to bring back the essence of the Glass-Steagall Act, and our markets sorely need this type of regulation.

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Article printed from InvestorPlace Media, http://investorplace.com/2010/02/volcker-rule-why-wall-street-needs-more-financial-regulation/.

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