Academic journal article Texas Law Review

Regulating Motivation: A New Perspective on the Volcker Rule

Academic journal article Texas Law Review

Regulating Motivation: A New Perspective on the Volcker Rule

Article excerpt

If you want to be trading, you have to have a lawyer and a psychiatrist sitting next to you determining what was your intent every time you did something.

Jamie Dimon, CEO of JPMorgan Chase & Co., Jan. 9, 20121

Introduction

The Volcker Rule is among the most controversial provisions of the Dodd-Frank Act. By banning proprietary trading by banks and their affiliates, the rule attempts to reduce the risk-taking of banks. But "proprietary trading" is an amorphous concept. The rule is intended to ban speculative trading aimed at profiting from short-term price movements. Many core functions of banks, however, entail the bank buying and selling financial instruments and assuming price risk as a principal for its own account. The Volcker Rule does not seek to constrain such trading if it is incidental to core financial intermediation functions, like market making, but rather only proprietary trading of a "speculative" sort. Determining whether a transaction constitutes banned proprietary trading therefore requires an inquiry into the motivation for the trade. Did the bank buy these securities to meet an anticipated client need or for some other permissible motivation, or is the bank just making a bet that their price is headed up?

The challenge in identifying the type of transactions that should be prohibited has led to a complicated scheme of definitions, presumptions, carve-outs, and quantitative tests. Roberta Romano argues that the resulting "Rube Goldberg-like Volcker Rule," at "over 900 pages," will "produce further surprises, in addition to imposing substantial compliance costs."2 While this is somewhat of an exaggeration on length-the regulatory release in total may run around 900 pages, but the text of the final rule itself is a mere 403-compliance is indeed expensive.

More fundamentally, the definitional challenges inherent in the approach create real risks of both under- and over-deterrence. Speculative trading at some banking entities may continue under the rule, while at others, socially valuable intermediation activities like market making may be inhibited out of fear that the necessary transactions would be mistaken for illegal proprietary trading. These problems also plague a similar proposal by the European Commission to define and ban proprietary trading at EU banks.4

Concerns about the cost and effectiveness of this "define and ban"-type regulation have led prominent academic commentators to conclude that the game is not worth the candle and to call for the repeal of the Volcker Rule,5 a call taken up in draft legislation recently introduced in Congress.6 Existing proposals for reform short of repeal entail tinkering with the same basic define-and-ban approach.7

But what if there were a better way to achieve the objectives of the Volcker Rule, at far lower cost, based on a fundamentally different regulatory strategy? Instead of the current define-and-ban approach, we propose that banks should simply not be permitted to pay compensation to traders based on trading profits. If banks cannot pay traders based on trading profits, neither the bank nor individual traders would want to engage in speculative proprietary trading, and banks would have incentives to devise their own schemes that permit trading that is incidental to core banking functions but eliminate speculative trading.

Our proposal takes advantage of the competition between firms in two key markets that are essential to proprietary trading: the securities market and the labor market for traders.8 First, firms that engage in the type of speculative trading targeted by the Volcker Rule compete in the securities market to identify and exploit trading opportunities. Doing so requires skill in acquiring and analyzing information that predicts future price movements of securities. Importantly, however, making bets on short-term price movements of securities is inherently a zero-sum game: for every winner, there is a loser. …

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