The Volcker Rule Will Be Squashed

There is finally talk of diluting the Volcker Rule. Ever since the Obama Administration has backed Paul Volcker's thoughts on eliminating proprietary trading from Wall Street, we have been trying to understand why. First, it is impossible to separate proprietary trading from customer accommodation. The political gurus may think they have the answers but how many of them actually have ever traded a stock or bond? Believe us, they don't know. Second, proprietary trading didn't create the financial crisis. It was too much leverage and Congress's policies to force increased home ownership to levels where those unable to afford homes were offered extremely cheap financing.

Many months ago we wrote about "too big to fail". The Volcker Rule is trying to address that issue by eliminating all risky businesses from the operations of banks. There is a better way to do it and a few weeks ago we wrote to Senator Dodd our thoughts. Those thoughts were just a rehash of the thoughts we wrote in this blog about "too big to fail".

Our main thesis relies on letting the banks and investment banks to regulate themselves. The financial system came close to the abyss because the leverage at many of our largest financial institutions was way too high. The solution is for the Fed to determine how much leverage a bank can have at varying asset sizes. Thus, a small bank may need X% equity to run efficiently and be well capitalized. However, as the company grows in size the percentage of equity will also grow. The Federal Reserve's historical perspective and the FDIC's guidance should be used to determine appropriate equity levels for varying bank sizes. The larger the bank, the larger the equity base. The percentage of equity should grow with an upward slope as bank assets increase.

Such a formula will put the onus on bank management to determine how big their institutions will become. As the bank grows, there will be a trade-off between size of assets and return on capital. The addition of new assets will likely have lower returns on capital as the regulations will require increased levels of capital. If the bank has diminishing returns as it increases its size, then the bank will slow its growth. The result will be a self regulating system. Managers of financial institutions focus on risk and return on capital. Regulators need to focus on capital requirements. Require enough equity capital for large banks and we won't be discussing "too big to fail" as those capital requirements will limit the growth.

This seems like a simple solution to many problems but Congress and the Administration need to think out of the box. The Volcker rule is the easy way out but it is impractical and is not the right solution. Let the banks self regulate.