May 14, 2012

Volcker Rule Untenable? Analyst Says JPMorgan’s Failed Hedge Is Proof

Fannie and Freddie failure forecaster Peter Wallison goes against current of opinion that $2 billion trading loss signals need for tighter regulation

American Enterprise Institute scholar and former White House counsel Peter Wallison says JPMorgan’s $2 billion trading blunder is not a reason to break up large banks.

In the immediate aftermath of last week’s $2 billion trading loss, both conservative and liberal voices have been heard calling for tighter regulation, but Wallison, in an interview with AdvisorOne and in a recent blog post, is swimming upstream amid the clamor to implement the Volcker Rule.

The Volcker Rule, a controversial part of the Dodd-Frank financial regulatory overhaul that is to take effect beginning in July, bans proprietary trading by commercial banks. But Wallison, who served as general counsel to the U.S. Treasury in the 1980s, says the JPMorgan incident “demonstrates that the Volcker rule is unworkable because you can’t tell the difference between a hedging strategy [which the Volcker Rule allows] and proprietary trading.”

The Obama administration today called for tighter, though unspecified, regulation of banks, and Wallison’s AEI colleague John Makin, in a separate blog post, said the JPMorgan trade indicated the necessity of implementing the Volcker Rule. (Makin could not be reached by AdvisorOne.) Former FDIC chairwoman Sheila Bair, an appointee of former President George W. Bush, told the Wall Street Journal Friday that regulators drafting Volcker Rule regulations should tighten the definition of hedging.

But to Wallison, all of this misses the point. “You can’t write a regulation that will instruct banks to hedge, which they’re required to do and allowed to do” and at the same time ban speculation because “it’s very hard to tell the difference,” Wallison told AdvisorOne.

In his blog, he added: “If the answer cannot be determined except by knowing all the circumstances surrounding a trade, and what was in the mind of the trader when the trade was put on, it is not suitable for a regulation.” Wallison also noted in his blog that the failed JPMorgan trade was apparently a hedging trade explicitly allowed by the Volcker Rule rather than a speculative trade.

Apart from the Volcker Rule issue, Wallison did not see the JP Morgan trading blunder as reason to break up large banks.

He acknowledged that large banks “have competitive advantages over small banks because people believe they are too big to fail” as a result of which they “will get preferential funding” and “swallow up the small banks.” But, he added, “what we don’t know is what size banks have to be so that they are no longer considered by the regulators as too big to fail. If a $2 trillion bank is too big to fail, would a $1 trillion bank not be too big to fail?” he asked.

“I don’t believe that just because a bank is large it is unmanageable,” he added.

Wallison, a veteran deregulation proponent at the free-market-oriented AEI, warned as early as 1999 that Fannie Mae and Freddie Mac would bring about a financial cataclysm, as they eventually did in 2007.

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