The Volcker Principles Move Closer To Practice

By Simon Johnson
Senators Merkley and Levin, with support from colleagues, are proposing legislation that would apply Paul Volcker’s financial reform principles – actually, much more effectively than would the Treasury’s specific proposals.  (Link to the bill’s text.)
Volcker’s original idea, as you may recall, is that financial institutions with government guarantees (implicit or explicit) should not be allowed to engage in reckless risk-taking.  At least in part, that risk-taking takes the form of big banks committing their own capital in various kinds of gambles – whether or not they call this proprietary trading.
At the Senate Banking Committee hearing on this issue in early February, John Reed – former head of Citi – was adamant that a restriction on proprietary trading not only made sense, but was also long overdue.  Gerald Corrigan of Goldman Sachs and Barry Zubrow of JP Morgan Chase expressed strong opposition, which suggests that Paul Volcker is onto something.
Of course, Goldman – among others – may seek to turn in its (recently acquired) banking license and go back to being “just an investment bank”, not subject to Fed regulation.  But raising this possibility is a feature, not a bug of the Volcker-Merkley-Levin approach.
Think through this logic – which I argued out with a very senior ex-Goldman person this weekend.
1)      If Goldman wants to be saved in the future, it needs to be subject to tough regulation – including this new restriction on proprietary trading.
2)      If it doesn’t want to be saved, that works for me.  But there is no way that Goldman at its current scale – or anything near – could fail without causing enormous collateral damage (literally).  Remember that there is no prospect of a “resolution authority” that will work for cross-border financial institutions, like Goldman (in private, top officials and leading bankers are willing to concede this).
3)      So if Goldman wants to escape the Volcker Rule, it will have to become much smaller.
4)      How small is open to discussion – but I would guess that this would be no larger than Goldman’s size in 1998 (around $270 billion in today’s dollars).  Given what we’ve learned about the limitations of everyone’s internal risk models, a sensible regulator would probably want to be even more conservative on size.
5)      My assessment is that if Goldman were around $100 billion in total assets, that would be a reasonable outcome – although we still have to worry about what they (or anyone) does in the “dark markets” of over-the-counter derivatives.
In any case, putting these issues openly on the table for Senate Banking – and on the floor of the entire Senate – is incredibly helpful.  The Volcker-Merkley-Levin proposal is concrete and feasible, and a useful part of how we can move forward.