Top researchers at the Stanford University Graduate School of Business are taking diametrically opposing views on the Volcker rule, one of the most important issues in financial reform. The sharp distinctions can be seen in their public comments to U.S. bank regulators writing the rule, the part of the Dodd-Frank law that restricts proprietary trading by very large banks.
Far from being of purely academic interest, the debate between these research teams cuts to the heart of the real economic and political issues at stake. (For more background on the proposed Volcker rule, I strongly recommend this comment letter by Better Markets, a nonprofit group that advocates stricter oversight.)
Darrell Duffie, a Stanford finance professor, is arguing that the Volcker rule will significantly undermine liquidity -- meaning how easy it is to buy and sell securities without moving prices -- in debt markets in the short run. He also says the rule probably will increase financial-stability risks over time, and potentially raise funding costs for nonfinancial companies. He proposes dropping the rule in favor of making sure banks have sufficient capital. Duffie seems confident that banks will have, or will be close to having, adequate capital because of the stricter requirements of the Basel III framework, the agreement by the Group of 20 countries and others on how banks should be funded.
Duffie’s work was commissioned by the Securities Industry and Financial Markets Association, which will pay $50,000 to a charity in lieu of compensating him. (Duffie discloses this point in his paper; I am not implying that anything about this debate is shaped by monetary payments. Duffie was also a founding member last year of the Academic Advisory Council of the Clearing House Association, a financial-sector lobby group; he is no longer on that Council.)
Three other Stanford finance professors -- Anat Admati, Peter DeMarzo and Paul Pfleiderer -- working with Professor Martin Hellwig from Germany agree on the importance of increasing capital, but insist that Basel III is just as poorly designed as its predecessors. In their assessment, there is virtually no chance that the largest banks will have adequate capital anytime soon. As a result, they have good reason to support the Volcker rule. These professors, experts on market microstructure and liquidity issues, believe the implications of inadequate capital trump everything else.
The key point made by Admati and her colleagues is that it isn’t enough to say vaguely “we’ll have more capital,” because the executives at big banks fight strenuously against higher capital requirements, for good reason (to them). Bank executives prefer relatively little equity financing and relatively more debt, meaning they have less capital (a synonym for equity in this context) and more leverage (meaning higher total assets relative to their loss-absorbing shareholder equity).
Less equity and more debt means higher payoffs when things go well, but bigger losses when mistakes are made or when traders are unlucky. Big banks benefit from implicit downside protection provided by the government. This is what it means to be “too big to fail.” Global banks have become a thinly disguised form of government-sponsored enterprise -- and it is natural that the people running them want their subsidies to continue and even increase over time.
Arguably, bank executives also represent the best interests of shareholders when they seek to protect subsidies, although the evidence from the last boom-bust cycle is that shareholders did poorly compared with the cash compensation received by insiders. Requiring 20 percent to 30 percent equity relative to total assets would work for Admati. (You can listen to her on this Planet Money podcast by National Public Radio.) Under Basel III, this measure, also known as the leverage ratio, is a mere 3 percent.
Switzerland, with about a 20 percent capital requirement, comes close to what the Admati team recommends, but it would be tougher than even the Swiss on the risk weights that banks can assign to various assets. Under Basel III, if banks put a lower risk weighting on some assets, it allows them to lower their capital, and thus effectively increase their borrowing capacity -- and ultimately the danger of a collapse.
This is a big part of what went wrong in the U.S. with mortgage-backed securities, and in Europe with sovereign debt. In both cases, the risk weightings proved completely wrong. The U.K. is discussing moving in the same direction as Switzerland, although the pushback from bankers is enormous. The reality in the U.S. is that capital, properly measured, is much lower and, even under Basel III, likely to be woefully inadequate for future cycles.
Duffie prefers to focus on liquidity and argues that the Volcker rule will have two main effects. First, in the short run, very big banks will do less market making, which will reduce liquidity and presumably increase bid-ask spreads. Second, over time, new market makers will enter the business, but they won’t be banks and hence not subject to the Volcker rule.
He is surely right that there will be new entrants, but why should we fear this? The Dodd-Frank law stipulates that any firm must be designated as systemically important if its failure would damage the rest of the system. This isn’t just about size, although size matters. MF Global Holdings Ltd., with about $41 billion in assets, failed without systemic implications even though it was a broker-dealer. Goldman Sachs Group Inc., with a balance sheet of around $900 billion, would surely pose systemic risks whether or not it remains classified as a bank holding company, a status it was granted by the Federal Reserve in September 2008 to prevent it from following Lehman Brothers Holdings Inc. into collapse.
How much capital would be enough from Duffie’s perspective? His comment letter doesn’t give a number and I haven’t found a number or range in his other work or public remarks to compare with the position of the Admati group. My private discussions with him have not clarified matters, either. To me, his position on capital remains frustratingly vague and very close -- although not identical -- to what I hear from financial industry groups (some of whom have cited Duffie favorably in my presence).
Even if Duffie is correct that the Volcker rule would have a short-term impact on liquidity, how large would this be? Again, I don’t find any estimates in his papers, so it’s hard to know what could guide policy here. In congressional testimony, other securities-industry representatives are similarly vague.
In any case, is maximum liquidity the right goal? Not necessarily, because a high degree of liquidity in good times can lull investors into a false sense of safety and reduce their incentive to do careful credit analysis.
The Admati team has it exactly right on the incentives of bank executives. Their ability to keep equity levels low is the Achilles’ heel of our system. They devote great resources through political contributions and other means to persuading policy makers to keep these subsidies in place.
Duffie instead devotes his efforts to emphasizing the importance of liquidity. But would restricting the proprietary trading of megabanks really have significant -- or any -- negative effects? Without question, the industry is solidly on his side, but it likes the existing subsidy structure. Why would we want to bet the house again on this industry’s special interest now being miraculously aligned with our broader social interest?
I’m going with the Admati, DeMarzo, Hellwig and Pfleiderer work on capital requirements and the analysis by Better Markets on the Volcker rule. Regulators would do well to push back hard against the financial-sector lobby as it seeks to undermine or undo a key component of the Dodd-Frank reforms.
(Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008 and is now a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is a Bloomberg View columnist. The opinions expressed are his own.)
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