Column: Listen to Volcker on regulation

Written by Jayanth R Varma | Jayanth R Varma | Updated: Jan 27 2010, 04:31am hrs
President Obama has proposed the Volcker rule preventing banks from running hedge funds, private equity funds or proprietary trading operations unrelated to serving their customers. Simultaneously, he also proposed size restrictions to prevent the financial sector from consolidating into a few large firms. While this might look like unwarranted government meddling in the functioning of the financial sector, I argue that, in fact, free market enthusiasts should welcome these proposals.

Obama has chosen to frame the proposal as a kind of morality play in which the long-suffering public get their revenge against greedy bankers. While that might make political sense, the reality is that the proposals are pro free markets. To understand why this is so, we must go back to the moral hazard roots of the global financial crisis.

These roots go back to 1998 when the US Fed bailed out the giant hedge fund, LTCM. The Fed orchestrated an allegedly private sector bailout of LTCM, but more importantly, it also flooded the world with liquidity on such a scale that it not only solved LTCMs problems, but also ended the Asian crisis almost overnight.

LTCM had no retail investors that needed to be protected. The actual reason for its bailout was the same as the reason for the bailout of AIG a decade later. Both these bailouts were in reality bailouts of the banks that would have suffered heavily from the chaotic bankruptcy of these entities.

Back in 1998, the large global banks themselves ran proprietary trading books that were also short liquidity and short volatility on a large scale like LTCM. A panic liquidation of LTCM positions would have inflicted heavy losses on the banks and so the Fed was compelled to intervene.

From a short-term perspective, the LTCM bailout was a huge success, but it engendered a vast moral hazard play. The central bank had now openly established itself as the risk absorber of last resort for the entire financial sector. The existence of such an unwarranted safety net made the financial markets complacent about risk and leverage and set the stage for the global financial crisis.

Those of us who like free markets abhor moral hazard and detest bailouts. The ideal world is one in which there is no deposit insurance and the governments do not bail out banks and their depositors. Since this is politically impossible, the second best solution is to limit moral hazard as much as possible.

If banking is an island in which the laws of capitalism are suspended, this island should be as small as possible, and the domain of truly free marketsfree of government meddling and moral hazardshould be as large as possible. Looked at this way, the Volcker rule is a step in the right direction. If banks are not shadow LTCMs, then at least the LTCMs of the world can be allowed to fail.

The post-Lehman policy of extending government safety net to all kinds of financial entities amounted to a creeping socialisation of the entire global financial system. The Volcker rule is the first and essential step in de-socialising the financial sector by limiting socialism to a small walled garden of narrow banking while letting the rest of the forest grow wild and free.

What about the second part of the Obama proposal seeking to limit the size of individual banks I see this as reducing oligopolies and making banking more competitive. Much of the empirical evidence today suggests that scale economies in banking are exhausted at levels far below those of the largest global banks, and there is some evidence that scale diseconomies set in at a certain level.

There is very little reason to believe that banks with assets exceeding, say, $100 billion are the result of natural scale economies. On the contrary, they appear to be the result of an artificial scale economy caused by the too-big-to-fail (TBTF) factor. The larger the bank, the more likely it is to be bailed out when things go wrong. It is therefore rational for a customer to bank with an insolvent mega-bank rather than with a well-run small bank.

This creates a huge distortion in which banks seek to recklessly grow to become eligible for the TBTF treatment. Well-run banks that grow in a prudent manner are put at a competitive disadvantage. This makes the entire financial sector less competitive and less efficient.

The Obama size restrictions will reduce the distortions created by the TBTF factor, and will make banking more competitive. One could argue that the restrictions do not go far enough because they legitimise the mega firms that already exist and only seek to prevent them from becoming even bigger. Nevertheless, it is in the right direction. It does not undo the damage that has already been done, but prevents further damage.

The author is a professor of finance at IIM Ahmedabad