How LTCM Renders the Volcker Rule Useless

“What is proprietary trading?” This is the key question surrounding the Volcker Rule. This key provision of Dodd-Frank reforms is the foundation of indirect accusations of bad faith by large financial institutions towards their customers and their shareholders alike.

Financial services industry critics are exploiting the Volcker Rule’s political savvy, but have failed to see that it is practically worthless.

On one hand the Volcker Rule, named after retired Fed executive Paul Volcker, harks back to long-repealed Glass-Steagall and the separation of retail from investment banking. It implies we can’t trust today’s banks to play fair with their own money and their customer’s at the same time.

On the other hand, the regulation implies that we cannot trust banks to invest prudently. This lack of trust becomes all the more valid when these institutions might become “too big to fail,” and their mistakes are too much for the regular economy to bear.

Herein lies the Volcker Rule’s political beauty. It is a rule that stops the smart people on Wall Street from making money off the rest of us – and it stops them dumping their losses from a large-scale screw up onto taxpayers.

What could possibly go wrong? The politicians seem to have thought of everything.

So why are a bunch of lobbyists making a boatload of money defanging the Volcker Rule?

Well there is the small point that the line between prop trading and running a bank is very fuzzy. Many experts still do not agree on whether or not the Volcker Rule would have averted JPMorgan’s recent multi-billion-dollar blunder. And what use are risk models if acting on the results and placing hedges to mitigate risk is deemed prop trading?

The Volcker rule is likely to be useless, even if it achieves its goal of stopping speculative trading in our financial utilities. It would be useless because of four letters: LTCM.

From a trust perspective, any bank that uses prop trading at the expense of its customers is not long for this world. From a too-big-to-fail perspective, Long Term Capital Management showed that independent asset management firms can place bets that are too-big-to-fail as well.

I agree we need to build some mechanisms that stop too-big-to-fail bets from being placed, but the mechanism seems to be eluding the regulators currently.