Volcker muddies debate about his own rule

Paul Volcker is muddying the debate about his own rule. The former Federal Reserve chairman has, along with other individuals, financial institutions and lobby groups, left it until deadline day to lodge comments about U.S. regulators’ proposals for banning proprietary trading. Overall, Volcker’s letter is a handy primer for why the rule is a good idea. That may have been useful when he floated the idea two years ago, but it is devoid of any practical advice for either the markets or their watchdogs.

There’s little point repeating the perils of prop trading. After all, banks have long since given up trying to argue that they should be allowed to keep prop units - even trading supremo Goldman Sachs capitulated early on that one. That said, Volcker still seems to have a very broad definition of what constituted prop trading losses in the crisis: surely only by adding losses created by poor balance sheet management can he come up with “hundreds of billions of dollars” of red ink.

In any event, the debate has now moved on from that. What worries banks and money managers far more is how the regulators define what constitutes market-making for clients. This is no easy trick and most of last year’s 300-page proposed rule was devoted to it. Wall Street’s fear is that too restrictive a rule will impede liquidity.

Volcker initially acknowledges this but then misses the point entirely, sticking with the old line that simply ending prop trading will have no effect. Worse, he’s now shifting gears by arguing that too much liquidity can be a bad thing as it can create asset price bubbles. That may be true. But too little liquidity can also create asset price slumps which in turn can drive up prices both for borrowers and for investors.

That could be a boon for foreign banks. Although they have their own fears about the effects of the Volcker Rule, they would stand to benefit if corporations and investors took their business abroad to markets which have, or could create, better liquidity.

Volcker’s newest argument seems a dangerous red herring. Regulators have more pressing fish to fry.