Volckier Rule is a Step in Right Direction

JPMorgan Chase, one of the nation’s largest banks, announced that it lost over
$2 billion in trading over the last few months. This has emboldened supporters
of the Volker rule, which prohibits banks that enjoy government support from
making risky investments other than loans. The Volker rule is a step in the
right direction of reducing the risk that banks take with their asset
portfolios.

Why should banks be treated differently than other financial institutions?
Financial intermediaries, including banks, take risks so that investors can
earn higher returns on their money. Banks, however, differ from other financial
intermediaries, such as mutual funds and brokers, in that deposit insurance
makes it possible for them to guarantee that depositors won’t lose their money,
regardless of how much risk the banks take. Investors whose money is at risk
will put pressure on a financial institution to limit risk, but insured
depositors have little motivation to monitor the riskiness of a bank’s
portfolio.

Many banks, as well as other financial institutions, invested in too many risky
assets prior to September 2008, which led to the financial crisis. The
financial crisis and government’s response to it are why we have a stagnant
economy with persistently high unemployment four years later. If government had
not stepped in to rescue bankrupt firms, the economy would have recovered more
strongly from the recession. A capitalist economy works well if firms that use
resources efficiently make profits and those that use resources inefficiently
lose money and eventually sell their assets to others who will find a more
valuable use for to them. This process of creative destruction plays a vital
role in promoting economic growth and prosperity as resources are continually
redirected toward those uses that most satisfy the demands of consumers.

Rather than [4]receiving bailouts, it would have been better if American
International Group (AIG), General Motors and Citigroup were left to resolve
their own financial problems, which would most likely have meant bankruptcy and
liquidation. Citigroup, however, is different than AIG and GM in that a
substantial share of its liabilities were deposits, which were insured by the
Federal Deposit Insurance Corporation (FDIC). Investors in corporations like
AIG and GM are warned that they might lose some or all of their investment.
Banks, by contrast, promise to return all money deposited, and depositors have
confidence in this promise.

The government grants banks privileges that other businesses do not have,
including deposit insurance and the power to create legal tender money. As my
fellow economist, [5]Dr. Shawn Ritenour, pointed out, MF Global got into big
trouble for using money from its customers’ accounts for its own trading, yet
banks do this legally all the time. If banks are going to lend out their
customer’s money, they should lend it as safely as possible, so there is little
question that it will be paid back. A bank, unlike MF Global, can get away with
trading using its customers’ money because the FDIC, which ultimately is backed
by the [6]Federal Reserve, guarantees that customers will get their money back,
even if the bank does not have enough in reserve to meet requests for
withdrawal. Regardless of how much money the FDIC needs to bail out bank
depositors, the Federal Reserve can create it.

Not only are depositors covered by insurance, but the federal government has a
longstanding practice of not allowing large banks to fail, providing bailouts
at taxpayer expense. It would be better if government did not rescue failing
banks and if deposit insurance were scaled back to cover only accounts of small
value. If banks did not have the implicit or explicit backing of the federal
government, the need to attract depositors and creditors would limit the risks
they would take. If deposit insurance only applied to small accounts, the risk
to taxpayers would be much less, and large depositors would put pressure on
banks to limit the riskiness of their investments.

It may be unrealistic to expect the government to scale back deposit insurance
or stop bailing out large banks that are on the verge of failure. For that
reason, the next best alternative is to implement the Volker rule to prohibit
proprietary trading by banks as well as maintaining more stringent controls
over the size and composition of banks’ loan portfolios. This will greatly
reduce the likelihood of another financial crisis like what we have just been
through.

© 2012 by The Center for Vision & Values at Grove City College. The views &
opinions
expressed herein may, but do not necessarily, reflect the views of Grove City
College.

[7]www.VisionAndValues.org | [8]www.VisionAndValuesEvents.com

References

1.
mailto:[email protected]?subject=Publication%2Fcitation%20notice&body=1.%20Submission%20title%3A%0A%0A2.%20Publication%28s%29%2Fmedia%20outlet%28s%29%3A%0A%0A3.%20Tentative%20publication%2Fcitation%20date%28s%29%3A
2.
http://www.visionandvalues.org/2012/06/volcker-rule-is-a-step-in-the-right-direction/
3. http://www.VisionAndValues.org/
4.
http://www.visionandvalues.org/2011/08/no-contest-the-reagan-stimulus-vs-the-obama-one/
5. http://www.visionandvalues.org/author/shawn-ritenour/
6. http://www.visionandvalues.org/2012/05/overhauling-the-federal-reserve-system/
7. http://www.VisionAndValues.org/
8. http://www.VisionAndValuesEvents.com/
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