Should We Trust Paid Experts On The Volcker Rule?

By Simon Johnson

On Wednesday morning, two subcommittees of the House Financial Services Committee held a joint hearing on the Volcker Rule.  The Rule, named for former Fed chair Paul Volcker, is aimed at restricting certain kinds of "proprietary trading" activities by big banks – with the goal of making it harder for these institutions to blow themselves up and inflict another deep recession on the rest of us.

The Volcker Rule was passed as part of the Dodd-Frank financial reform legislation (it is Section 619) and regulators are currently in the process of requesting comments on their proposed draft rules to implement.  Part of the issue currently is claims made 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 therefore slowing economic growth.

This argument rests in part on a report produced by Oliver Wyman, a financial consulting company.  Oliver Wyman has a strong technical reputation and is most definitely capable of producing high quality work.  But their work on this issue is not convincing.  (The points below are adapted from my written testimony and verbal exchanges at the hearing; the testimony is available here.)

The report, "The Volcker Rule: Implications for the US corporate bond market," was commissioned by the Securities Industry and Financial Markets Association (SIFMA) and it is available on the SIFMA webpage that contains its comment letters to regulators.  On p. 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 also includes executives from Morgan Stanley, Societe General, UBS, BNP Paribas, HSBC, Deutsche Bank, Goldman Sachs, Citigroup, RBS, JP Morgan Chase, Credit Suisse, RBC, 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 – this is according to the Oliver Wyman report, p. 11, which 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 likely cause massive 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 firms (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 also operate proprietary trading at any significant scale – this is clear from the repeated public statements of both Mr. Volcker (who had the original idea) and Senators Carl Levin and Jeff Merkley, who turned it into meaningful 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 also have a fiduciary responsibility to do all they to ensure the subsidies continue (i.e., 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 their public materials to suggest the research they sponsor is designed to uncover true social costs and benefits; rather their goal is to advance the interests of their members – this is a lobby group, after all.  SIFMA claims to represent 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 Oliver Wyman study draws heavily on a paper by Jens Dick-Nielson, Peter Feldhutter, and David Lando, which looks at the liquidity premia for corporate debt in recent years and which contains plausible results: "Illiquidity premia in US corporate bonds were large during the subprime crisis. Bonds become less liquid when financial distress hits a lead underwriter" (quoted from http://www.feldhutter.com/).  (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 their article.)

However, the Olivier Wyman study goes far beyond those academic authors when it claims 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 generally an appealing way to conduct research.

Specifically, the Oliver Wyman 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 – can raise outside capital and continue doing an equivalent version of his or her job.  Now, however, these traders will bear more of their own downside risks.

If it turns out that the previous form or extent of trading only existed 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 in the depth of the financial crisis, 2007-2009.   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-Nielson, Feldhutter, and Lando paper.  If Oliver Wyman had used instead the pre-crisis period estimates from the authors, covering the period 2004-2007, even giving their own methods the implied effects would be 5-20 times smaller (this adjustment is based on my discussions with Peter Feldhutter.)

And the Oliver Wyman study 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 Rule.  But for-hire "research" that shows the Volcker Rule will hurt the broader economy should not be regarded as convincing evidence.

An edited version of this post appeared last week on the NYT.com Economix blog; it is used here with persmission.  If you would like to reproduce the entire post, please contact the New York Times.