Banking: The Volcker Plan is Insufficient

Ever since the financial crisis erupted, a general complaint has been the need to establish new regulations for banks and the financial system. Many people believe that the origins of the crisis are to be found in the fierce deregulation of the financial sector. But the Obama administration has taken an entire year to begin addressing this outcry. Now that it has begun to do so, it seems that its proposals for change are insufficient.

Financial deregulation has a long history, beginning in 1978, when a Supreme Court decision (Marquette vs. First of Omaha) permitted banks to extend their usury practices to all of the states of the union. With Reagan, the Garn–St. Germain Depository Institutions Act of 1982 deregulated savings and loans, which caused the crisis of the sector at the end of the decade.

In 1994, restrictions on interstate banking activities were eliminated with the Riegle-Neal Act. In 1996, the Federal Reserve reinterpreted the Glass-Steagall Act, permitting various commercial banks to earn up to 25 percent of their total profits from investment banking activities. According to the Glass-Steagall Act of 1933, commercial banking (with its prudent management) should be separated from investment banking (which accepts higher risks). The banking lobby triumphed in 1999 when the Gramm-Leach-Bliley Act overturned the Glass-Steagall Act.

In 2000 the [federal] Commodity Futures Trading Commission was prevented from regulating the trading of unlisted derivatives. Finally, in 2004, a system of voluntary regulation was established, allowing the investment banks to operate with lower reserves and greater levels of leverage.

In this way, perverse incentives were established, and the base was set for an explosive growth of risk. The crisis was nothing more than a predictable tragedy. Therefore, when Obama announced an initiative to re-regulate banking activities, it garnered much applause. The initiative was prepared by Paul Volcker, his special advisor for economic recovery.

For Volcker, the big banks should not use the deposit insurance system to support their speculative operations. His plan has two objectives. The first is to limit the size of banks so that in a crisis they will not endanger the integrity of the entire banking system. But it remains to be seen what the criteria will be for limiting the size of the banks; the devil is in the details.

The second objective is to impede financial transaction which banks carry out for their own account in order to obtain speculative profits. These activities introduce additional risks to those of traditional banking activity. One of the targets of the reform is Goldman Sachs, a corporation that gets 10 percent of its profits from these transactions.

But the Volcker plan has loopholes that an elephant could fit through. To begin with, the rules only apply to institutions that take deposits. Goldman Sachs or Morgan Stanley, for example, could avoid the Volcker plan and continue their speculative operations if they get rid of the small deposit base they currently have.

In another matter, banks will be able to continue running hedge funds and other investment funds as long as these transactions are done in their clients’ names (instead of being vehicles for speculative investment with the bank’s own resources). But this is dangerous. The crisis demonstrated that the dividing line between client transactions and proprietary transactions is very unclear. During the crisis, many banks ended up rescuing powerful clients who had been hurt in transactions of dubious quality. And the worst part is that the banks could avoid the Volcker plan by simply removing their capital from the hedge funds that they are managing; in this way they could always claim that all of their operations are done on behalf of their clients.

The Volcker plan will not stop banks from carrying out speculative transactions in the commodities futures markets. They only have to prove that they are operating on behalf of clients. In fact, businesses specializing in commodities transactions (like Trafigura, Glencore or Vitol) will benefit from the exclusion of banks from this sector. Many analysts believe that in the fight for market share, volatility will increase. We must not forget that the price increase in oils and grains of two years ago was related to the speculative activities of banks, funds, insurance companies and other large participants in the futures markets. The crisis of high food prices could get worse in the months to come.

Deregulation is without a doubt one of the roots of the crisis. But the Volcker plan is too timid to rein in the speculative avalanche of the United States economy.