March 21, 2023

Economix Blog: Simon Johnson: Should We Trust Paid Experts on the Volcker Rule?


Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

On Wednesday morning, two subcommittees of the House Financial Services Committee held a joint hearing on the Volcker Rule, which is named for the former chairman of the Federal Reserve, Paul Volcker, and is aimed at restricting certain kinds of “proprietary trading” activities by big banks. Its goal is to make it harder for these institutions to blow themselves up and inflict another deep recession on the rest of us.

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The Volcker Rule was passed as part of the Dodd-Frank financial reform legislation (it is Section 619), and regulators are currently requesting comments on their proposed draft rules to carry it out.

Part of the current issue is contentions by some members of the financial services industry that the Volcker Rule will restrict liquidity in markets, pushing up interest rates on corporate debt in particular and slowing economic growth.

This assertion rests in part on a report produced by Oliver Wyman, a financial consulting company. Oliver Wyman has a strong technical reputation and is definitely capable of producing high-quality analysis, but its work on this issue is not convincing, for three reasons. (The points below are adapted from my written testimony and verbal exchanges at the hearing.)

The report, “The Volcker Rule: Implications for the U.S. Corporate Bond Market,” was commissioned by the Securities Industry and Financial Markets Association, or Sifma, and is available on the Sifma Web page that contains its comment letters to regulators.

On Page 36 of the report, the disclaimer begins, “This report sets forth the information required by the terms of Oliver Wyman’s engagement by Sifma and is prepared in the form expressly required thereby.”

This does not mean – and I am not implying – that Oliver Wyman was instructed to find a particular kind of result. But the incentives of Sifma and its most prominent members are worth further consideration in this context.

The current chair of Sifma is Jerry del Missier, a top executive at Barclays Capital. The board includes executives from Morgan Stanley, Société Générale, UBS, BNP Paribas, HSBC, Deutsche Bank, Goldman Sachs, Citigroup, Royal Bank of Scotland, JPMorgan Chase, Credit Suisse, Royal Bank of Canada and Merrill Lynch.

All of these companies would be affected by the Volcker Rule, in the sense that they would have to give up some of their “proprietary trading” activities and perhaps be subject to other restrictions – as is noted by the Oliver Wyman report, which on Page 11 lists “the institutions that will be most affected by the Volcker Rule”; more than half of these institutions are on the Sifma board.

Such very large banks are perceived as too big to fail because their failure would be likely to cause huge damage to the rest of the financial system. As a result, the downside risks created by these institutions are borne, in part, by the government and the Federal Reserve – as a way to protect the rest of the economy.

In effect, these banks benefit from unfair, nontransparent and dangerous government subsidies that encourage reckless gambling – most notably in the form of “proprietary trading” (jargon for placing bets on which way markets will move).

When things go well, the benefits of these arrangements are garnered by the executives who run these companies (and perhaps shareholders). When things go badly, the downside costs are pushed in various ways onto the taxpayers and all citizens.

The Volcker Rule is intended to limit the implicit subsidies received by large banks that operate proprietary trading at any significant scale; this is clear from the repeated public statements of Mr. Volcker (who had the original idea) and Senators Carl Levin, Democrat of Michigan, and Jeff Merkley, Democrat of Oregon, who turned it into legislation as an amendment to Dodd-Frank.

We should therefore expect executives from big banks to oppose removal of these subsidies. To the extent that such subsidies may be expected to benefit shareholders, it can be argued that these executives have a fiduciary responsibility to do all they can to ensure that the effectiveness of the Volcker Rule be undermined.

Sifma itself has a clear mission: “On behalf of our members, Sifma is engaged in conversations throughout the country and across international borders with legislators, regulators, media and industry participants.”

There is nothing in its public materials to suggest the research it sponsors is intended to uncover true social costs and benefits; rather their goal is to advance the interests of their members. This is a lobbying group, after all.

Sifma asserts that it represents the entire securities industry, but more than one-third of its board is drawn from very large banks that would find their implicit subsidies cut and constrained by an effective Volcker Rule. Given this context, it is not clear why the Olivier Wyman study would be regarded as anything other than – or more convincing than – a relatively sophisticated form of special interest lobbying.

There is also a serious methodological issue. The study draws heavily on a paper by Jens Dick-Nielson, Peter Feldhutter and David Lando that looks at the liquidity premiums for corporate debt in recent years and contains plausible results. As Professor Feldhutter writes on his Web site: “Illiquidity premia in U.S. corporate bonds were large during the subprime crisis. Bonds become less liquid when financial distress hits a lead underwriter.” (Disclosure: Until recently I was on the editorial board of the Journal of Financial Economics, where the paper appeared, but I was not involved in the publication of this article.)

The Olivier Wyman study, however, goes far beyond those academic authors when it asserts that the Volcker Rule will make corporate bonds less actively traded – less liquid – and therefore increase interest rates on such securities. In particular, the Oliver Wyman approach appears to assume the answer – which is not an appealing way to conduct research.

Specifically, the study assumes that every dollar disallowed in pure proprietary trading by banks will necessarily disappear from the market. But if money can still be made (without subsidies), the same trading should continue in another form. For example, the bank could spin off the trading activity and associated capital at a fair market price.

Alternatively, the relevant trader – with valuable skills and experience – could raise outside capital and continue doing an equivalent version of his or her job. These traders would, of course, bear more of their own downside risks.

If it turns out that the previous form or extent of trading existed only because of the implicit government subsidies, then we should not mourn its end.

The Oliver Wyman study further assumes that the sensitivity of bond spreads to liquidity will be as it was in the depth of the financial crisis, 2007-9. This is ironic, given that the financial crisis severely disrupted liquidity and credit availability more generally – in fact this is a major implication of the Dick-Nelson, Feldhutter and Lando paper.

If Oliver Wyman had used instead the pre-crisis period estimates from the authors, covering the period 2004-7, even giving their own methods the implied effects would be one-fifth to one-twentieth of the size (this adjustment is based on my discussions with Professor Feldhutter).

The Oliver Wyman study also makes no attempt to estimate the benefits of the Volcker Rule, for example in terms of lower probability for a major financial collapse.

The biggest disaster for the corporate bond market in recent years was a direct result of excessive risk-taking by big financial players. The Volcker Rule is a step in the direction of making it harder to repeat that awful experience.

Powerful players in the financial sector are entitled to make their arguments against the Volcker Rule. But for-hire “research” that shows the rule will hurt the broader economy should not be regarded as convincing evidence.

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