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Is the Volcker Rule a Step in the Right Direction?

JPMorgan Chase, one of the nation’s largest banks, announced that it lost over $2 billion in trading over the last few months. This has emboldened supporters of the Volker rule, which prohibits banks that enjoy government support from making risky investments other than loans. The Volker rule is a step in the right direction of reducing the risk that banks take with their asset portfolios.

Why should banks be treated differently than other financial institutions? Financial intermediaries, including banks, take risks so that investors can earn higher returns on their money. Banks, however, differ from other financial intermediaries, such as mutual funds and brokers, in that deposit insurance makes it possible for them to guarantee that depositors won’t lose their money, regardless of how much risk the banks take. Investors whose money is at risk will put pressure on a financial institution to limit risk, but insured depositors have little motivation to monitor the riskiness of a bank’s portfolio.

Many banks, as well as other financial institutions, invested in too many risky assets prior to September 2008, which led to the financial crisis. The financial crisis and government’s response to it are why we have a stagnant economy with persistently high unemployment four years later. If government had not stepped in to rescue bankrupt firms, the economy would have recovered more strongly from the recession. A capitalist economy works well if firms that use resources efficiently make profits and those that use resources inefficiently lose money and eventually sell their assets to others who will find a more valuable use for to them. This process of creative destruction plays a vital role in promoting economic growth and prosperity as resources are continually redirected toward those uses that most satisfy the demands of consumers.

Rather than receiving bailouts, it would have been better if American International Group (AIG), General Motors and Citigroup were left to resolve their own financial problems, which would most likely have meant bankruptcy and liquidation. Citigroup, however, is different than AIG and GM in that a substantial share of its liabilities were deposits, which were insured by the Federal Deposit Insurance Corporation (FDIC). Investors in corporations like AIG and GM are warned that they might lose some or all of their investment. Banks, by contrast, promise to return all money deposited, and depositors have confidence in this promise.

The government grants banks privileges that other businesses do not have, including deposit insurance and the power to create legal tender money. As my fellow economist, Dr. Shawn Ritenour, pointed out, MF Global got into big trouble for using money from its customers’ accounts for its own trading, yet banks do this legally all the time. If banks are going to lend out their customer’s money, they should lend it as safely as possible, so there is little question that it will be paid back. A bank, unlike MF Global, can get away with trading using its customers’ money because the FDIC, which ultimately is backed by the Federal Reserve, guarantees that customers will get their money back, even if the bank does not have enough in reserve to meet requests for withdrawal. Regardless of how much money the FDIC needs to bail out bank depositors, the Federal Reserve can create it.

Not only are depositors covered by insurance, but the federal government has a longstanding practice of not allowing large banks to fail, providing bailouts at taxpayer expense. It would be better if government did not rescue failing banks and if deposit insurance were scaled back to cover only accounts of small value. If banks did not have the implicit or explicit backing of the federal government, the need to attract depositors and creditors would limit the risks they would take. If deposit insurance only applied to small accounts, the risk to taxpayers would be much less, and large depositors would put pressure on banks to limit the riskiness of their investments.

It may be unrealistic to expect the government to scale back deposit insurance or stop bailing out large banks that are on the verge of failure. For that reason, the next best alternative is to implement the Volker rule to prohibit proprietary trading by banks as well as maintaining more stringent controls over the size and composition of banks’ loan portfolios. This will greatly reduce the likelihood of another financial crisis like what we have just been through.

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