Earlier today, the consulting firm IHS released a report decrying the horrible consequences that the Volcker Rule would have for the US energy industry and the economy.
It’s a hatchet job.
There are 2 essential fallacies at the heart of the IHS report. And many other ones, too, but let’s focus on the essential ones.
First, the report assumes its conclusion. The Volcker Rule bans banks from proprietary trading. But the Volcker Rule does not ban anyone else from proprietary trading. The IHS report assumes that when banks stop proprietary trading, no one else will step in and do so.
That’s a ridiculous assumption. Let’s look at other industries where governments sometimes regulate which institutions may and may not operate – take alcohol sales, for example. Suppose a state were to ban grocery stores from selling alcohol. Does that mean alcohol would not be sold? Obviously not.
So why does IHS assume that if bankers stop providing this service, no one else would step in to do so. The report never explains.
It’s a long, bloated report. But only after 91 pages (electronic count)… in the conclusion no less … do the authors get around to addressing the critical assumption. When they do, all they can say is:
U.S. banks’ deep knowledge of the complexity of energy and financial markets cannot be replaced quickly.
Quickly? So now, the issue is quickly? So finally, at the end, the authors tell us that the real issue is just the speed of implementation. Does IHS mean that the Volcker Rule would be a good idea, but we must implement it slowly, so as to give new businesses time to step into the breach? Certainly the Executive Summary does not seem in line with that nuance in the conclusion.
Anyway, is that even true?
There is no analysis leading to that assertion. All of the analysis in the report was wasted on calculations that assumed the conclusions. None was spent on supporting it.
But wait a second! Why do we need to have time to replace the bankers who now do proprietary trading? The Volcker Rule does not instruct us to take the banks’ proprietary traders out to the woods and shoot them. They don’t disappear. We don’t have to replace them. The Volcker Rule simply says that the proprietary trading desks of the banks should be separated from the banks. They can be sold as is. In fact, even without the Volcker Rule these desks often change hands overnight. Pre-Dodd-Frank it was not uncommon for whole trading operations to move from one corporate holding company to another. Nothing disappears. Nothing needs to be replaced. It’s just a reorganization of the corporate legal structures, nothing more. The economy keeps on humming.
So the IHS report assumes its conclusion. All of the ginormous economic costs that it tallies assume that because the banks don’t provide the service, the service is not provided. Not at all. Silly.
Should we dig deeper? Perhaps there is something special about banks? That would be an interesting hypothesis to explore. But it’s not one that the IHS report explored. In fact, if the IHS report had bothered to investigate the question of “why banks”, the answer might have helped explain why the Volcker Rule is such a sensible bit of financial regulation. That brings us to the second fallacy…
Second, the report ignores taxpayer subsidies to bank risk taking. If banks are better at providing this intermediation, then by all means, let’s do it through banks. But that is not the reason this activity moved onto bank balance sheets. It happened because banks do not pay the full cost of the risks they fund – taxpayers do. Ignore the taxpayer subsidy, and, of course, it looks wise to allow the banks to keep doing the business. But accounting for the subsidy, it makes no sense.
IHS ignores taxpayer subsidies to banks.
Here’s one example. Unmargined OTC derivatives sold by banks entail credit risk. But, pre-Dodd-Frank, banks did not properly account for that credit risk. They could ignore or minimize that credit risk in their reports to their regulators, and, as a result, they didn’t have to hold capital against it. The capital backstopping the risk was taxpayer capital, and banks didn’t pay for it. They only profited at taxpayer expense.
When the IHS report tallies up the economic damages it alleges will follow from the Volcker Rule, IHS ignores capital market distortions like this one.
Protecting hidden subsidies to banks is not a sensible economic policy. The U.S. economy is still paying mightily for that mistake. IHS ignores the huge costs imposed on taxpayers and the economy as a whole from bad bank regulation. Sensible economic policy means getting prices and incentives right, and letting businesses optimize against those. The Volcker Rule is about ending hidden taxpayer subsidies to risky transactions by banks. That was always what it was about. From the very beginning.
So why does an IHS report that pretends to evaluate the Volcker Rule ignore the very purpose of the Rule?