Tuesday, February 7, 2012

Volcker Rule

A smart student asked me last week what I thought of the Volcker Rule which disallows regulated banks from engaging in proprietary trading. Europeans loved it at first. They hate it now, because it may stop U.S. banks from buying European sovereign debt. Our dollars are all of a sudden not so undesirable. Gisele Bundchen is probably taking them, even though a few years ago she wanted to be paid in euros...
Anyway, I don't know if there is any problem with the Volcker rule, but there is moral hazard in banking regulation itself. Imagine the world where banks are not regulated at all. Before depositing our hard-earned money in a bank, you and I would investigate whether the bank is safe and how leveraged it is. The bank would have to earn our trust and keep perhaps as much as 20-50% of the deposits on hand. In the world of regulated and deposit-insured banks, we don't investigate. Our depostis are safe, because the government insures them. That is, the risk is transferred completely to the tax payer. The bank, to earn profits, levers up 20-30 times and engages in risky lending and trading. It is the regulation itself that makes banks risky. The Volcker Rule is an over-regulation solution to an over-regulation problem.

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