PARTICIPANTS
Darrell Duffie, Michael Bordo, Joe Grundfest, Allan Meltzer, Ken Scott, George Shultz, Kimberly Summe, John Taylor, Ian Wright, Yuri Yarim-Agaev
ISSUES DISCUSSED
Darrell Duffie discussed the portion of the Dodd-Frank Act known as the “Volcker Rule,” which restricts the amount of proprietary trading that may be done by financial institutions. He explained both the intended and unintended effects of the rule’s proposed implementation.
Duffie began by clarifying that proprietary trading means trading on one’s own account, rather than for a customer, but is often misunderstood as meaning trading in speculative investments. Hence, the Volcker Rule restricts the trading banks may do that is not directly on behalf of their customers. Thus, while the rule’s objective is to lower the risk of banks stemming from trading while still allowing banks to make markets, hedge and underwrite, the side effects of the proposed implementation will be a reduction in the liquidity of financial markets in years following the Act’s implementation, as well as significant migration of market making to outside of the regulated banking sector where there is less supervision.
Duffie gave a couple of examples, such as the hedging exemption, demonstrating that the language used to describe permissible trading under the Volcker Rule is difficult to make robust and is very loose and malleable, permitting a wide range of outcomes. He also pointed out that the recent losses incurred by JP Morgan due to its trading would have been difficult to judge as acceptable or not under the rule’s language. More generally, it is difficult under the proposed implementation to determine what type of market making and trading is permissible and what type is not.
Duffie concluded by arguing that even if one could fine-tune written rules sufficiently to limit risk-taking behavior, the rules would still be very hard to implement. Thus, he stated that rather than trying to micro-manage and draw lines between market making and non-market making activity, it is wiser to have a wide boundary around market making, hedging and underwriting and instead implement broader and more robust capital and liquidity requirements for financial institutions.
