Politico Op-Ed: The Government's Loophole in the "Volcker Rule"

Feb 13, 2012

A variety of criticisms have been lobbed against the Dodd-Frank financial regulatory reforms since they became law in 2010.

Banks and other financial services firms have justifiably claimed the 2,000-page law would prove unworkable and effectively increase the cost of credit. Proponents of Dodd-Frank, on the other hand, largely dismiss the critics’ cries as the unwarranted arguments of an industry deserving more oversight.

In one area, though, the irony has proved to be especially rich. When the federal government realized how one Dodd-Frank provision could have affected its own borrowing costs — the so-called Volcker rule — the new rules did not seem so fair.

So, what to do? Congress created a loophole, exempting the federal government.

Buried in the pages of Dodd-Frank is a paragraph that says U.S. Treasury security traders, propriety and market-makers alike, can largely act as they please.

But why?

Proprietary traders could just as easily lose their firms billions of dollars with a wrong-way bet on a U.S. 10-year note as they could with a wrong-way bet on a General Electric corporate security. And the idea that sovereign debt is risk free is coming under attack globally. Yet under the Volcker rule, named after former Federal Reserve Chairman Paul Volcker, government bond traders can trade as they like — for proprietary reasons, for hedging or both.

The true motivation here is as obvious as it is duplicitous. Treasury and the Fed, which collectively rely on primary dealers and traders to buy the bonds they issue, knew that if the regulation applied to Treasury securities, it would lead to higher borrowing rates for the government.

How could it not? Traders add liquidity to markets, and liquidity lowers borrowing costs. The Volcker rule portends to get inside the head of a trader and determine the motivation behind a particular trade. But this will prove a fool’s errand.

The net effect of this rule, as crafted with the government bond carve-out, will simply be to give the government a comparative funding advantage over private firms in raising capital. Pension funds and other investors will face a choice: Invest in a Treasury, which has seen no decrease in liquidity as trading of all stripes is permitted, or purchase a private-sector corporate security in which liquidity may be scarce. The decision is easy: Buy the government bond.

This dynamic will simply put further strain on the private-sector institutions that are meant to be the true drivers of economic growth and job creation — and most assuredly not make the banking system any safer.

These complaints aren’t just theoretical. Recently, the governments of Japan and Canada, collectively some of our most important trading partners, have voiced strong criticism over the rule, saying they know it will impact their ability to issue debt.

Remember, they were not fortunate enough to secure for themselves a carve-out. So they know they’ll face higher borrowing costs. Canada even went so far as to suggest that the Volcker rule may be a violation of long-held free-trade rules.

A recent study published by the international management consulting firm Oliver Wyman estimates that in the first year alone, the rule could raise coupon costs for corporate debt issuers by as much as $6 billion. Over time, as more and more bonds are rolled over, this additional toll could reach $43 billion each year, the study estimates. And all of this means that American companies will face higher borrowing costs and more headwinds to growth.

There is a better approach to reducing financial-sector risk than embracing policies that only further shift the burden to the private sector.

Our focus needs to be on actually improving the fundamentals of the banking system as opposed to overly complex measures like the Volcker rule, especially as drafted by the regulators. Banks that are well managed, well capitalized and well regulated are far less likely to fail. The problem in 2008 was that too few financial institutions fit the bill on any of these fronts.

We must work on reforms that address some of the system’s weaknesses at its core: establish a better capital regime in which risk weightings do not allow for capital arbitrage, get the government out of mortgage lending and other such businesses and find ways to streamline regulation to strike a proper balance between oversight and policies that inhibit growth. 

If we can do these things — and I’m hopeful we can — Congress would offer some meaningful solutions to real problems and truly make our financial system sounder.

It would be a welcome change.

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