Volcker Says More Market Liquidity Doesn’t Bring Public Benefit

In response to the harsh lobbying efforts by a number of the world’s largest banks against his eponymous rule, Paul Volcker has stated that less liquidity – an expected effect of the Volcker Rule – will not harm the public interest. In fact, Volcker notes, “great liquidity, or the perception of it” can lead to dangerously risky behavior, as it did overtly in the run-up to the current financial and economic crisis.

By Yalman Onaran

BusinessWeek

February 14, 2012

Former Federal Reserve Chairman Paul Volcker said those attacking his namesake rule for reducing trading activity in capital markets ignore that higher volumes may actually lead to bigger risk-taking.

“There should not be a presumption that evermore market liquidity brings a public benefit,” Volcker, 84, wrote in a letter submitted yesterday to regulators in defense of the rule curtailing banks’ bets on asset prices with their own money. “At some point, great liquidity, or the perception of it, may itself encourage more speculative trading.”

Congress included the so-called Volcker rule in the Dodd- Frank Act financial-reform package it passed in 2010, leaving the specifics of implementation to regulators. Yesterday was the deadline for comments on guidelines proposed by the Fed and other bank supervisors on how the rule would be put in place.

Banks have argued that the rule would constrain their efforts to broker client trades while attempting to curtail their proprietary trading. That would reduce liquidity, make transactions more expensive for investors and raise borrowing costs for firms, according to banks and some fund managers.

Republican Congressmen have also criticized the rule, which was passed when Democrats had majority in both chambers. Republican Representative Spencer Bachus of Alabama, who chairs the House Financial Services Committee, said last month that the rule was misguided because proprietary trading didn’t cause the 2008 financial crisis. Volcker in his letter argued that it did.

‘Spectacular Trading Losses’

“The recent years of financial crisis have seen spectacular trading losses in large commercial and investment banks here and abroad,” Volcker said. “Consequently, the stability of important banks was jeopardized, contributing to a financial crisis of historic dimension.”

Between mid-2006 and 2010, the six largest U.S. banks had 13 quarters of trading profits while recording losses in five, according to calculations by Mark Williams, a professor at Boston University. During the positive quarters, the lenders made a total of $15.6 billion in trading profits while losing $15.8 billion in less than half the time in the losing periods, Williams found.