03/24/2010 05:12 am ET | Updated May 25, 2011

The Volcker Plan: First Thoughts

Chaos. Confusion. Bewilderment. Twenty-four hours after the president's big announcement there's still an awful lot of head scratching going on about the Volcker Plan. Perhaps it will now begin to clear. But the rhetoric, the talk, the reporting haven't cleared up the biggest questions, the most obvious of which is that it's very difficult to see how this plan a) would have avoided the financial crisis in the first place or b) deals with the largest, hairiest, most chronic problems out there, the tangle of too-big-to-fail and moral hazard. Obama's statement Thursday only added to the confusion by slinging around terms, like TBTF and proprietary trading, whose technical definitions are murky at best.

It was, in short, pretty obviously a political speech, the silliest part of which was his ringing declaration that this plan would insure that "never again" would banks be too big to fail. First, saying "never again" is a dangerous fantasy. Second, even a cursory examination of the plan suggests it's far less about size and systemic impact and far more about conflict, speculation and politics.

Obama continually emphasized deposits, a very Glass-Steagallian concept, as if it was 1933 all over again, and yet as far as I know no deposits were lost because bankers went gambling, and indeed, because of deposit insurance, no consumer lost deposits because of the crisis. Similarly, prop trading, hedge funds and private equity may scare people, but those activities, narrowly defined (as they will be by the banks and their lawyers and lobbyists), had nothing to do with the subprime and structured finance meltdown either; in some cases, prop trading helped out these firms. If you define, on the other hand, prop trading with investing bank capital (that is, deposits) in profit-making efforts, then everything from credit cards to corporate lending to structured finance might fit under that capacious awning. Banks invest other people's money for their own profits. That's what they do. Where then is the line drawn? It's easy to say that trading for your own book would apply, but what if you sell your loans into the market, then trade on that market? What if you trade to remain in the deal or information flow or to provide liquidity? Where does securitization fit into all this?

Obama also mentioned plans to install some form of cap on assets at risk, although the papers today described an enforcement mechanism that was hardly draconian: a ban on acquisitions as a bank approached that cap, although organic growth would be allowed to continue. This raises a host of questions. What's the cap? How is it determined? Why the emphasis on acquisitions -- as opposed to automatic hikes in capital and leverage, or divestitures? (Many banks grew by acquisition, like Bank of America Corp. [NYSE:BAC], Citigroup Inc. [NYSE:C] and J.P. Morgan Chase & Co. [NYSE:JPM], but high-octane risk-takers like Goldman, Sachs & Co. [NYSE:GS] and, of course, Bear Stearns Cos. and Lehman Brothers Holdings Inc. did not for the most part. In the case of Lehman, the most stable part of the company came from an acquisition, Neuberger Berman.)

For all of that, the real problem with the cap is how dangerously crude it is. Risk is dynamic and, as we know, results from interconnection as much as sheer size. A cap on assets at risk will not get us to the real issue, which is where assets are dangerously pooling. And, in fact, because it would tend to become the metric of choice for risk, it may well distract regulators from looking deeper, particularly as time passes.

What kind of system does Obama envision here? The big banks will remain big, even if they give up some hedge funds, private equity and narrowly defined prop trading. Institutions cross-dressing as banks, like Goldman or Morgan Stanley (NYSE:MS), may choose to surrender holding company status and go it alone again (or they may not once they've read the fine print). But it's very difficult to see how they will suddenly and significantly shrink in size and, more importantly, shed their well-deserved statuses, because of their dense interconnectivity, as systemic risks. The clearest part of this plan is to eliminate a few conflicts, most of which exist, as Lloyd Blankfein testified last week, among sophisticated investors who should presumably know what they're doing (although we should be skeptical that anyone truly knows what they're doing when it comes to the markets). The clear hope, particularly from the Volcker camp, is that this plan will strip out much of the speculation from regulated "banks." That is the heart of this problem, but speculation is a concept mired in ambiguity. Your speculation is my investment. My investment was an investment until it went bad and became a speculation. Your hedge is my bet. My hedge is my bet. Where is that line drawn, not only on vehicles we fully understand, but also on complex synthetic instruments that, at times, can arguably flash both traits at the same time?

Might the world be a better place if we could shrink the level of speculation that has -- more debate unburdened by empirical facts -- no real economic value? Undoubtedly. But to do so might well mean eliminating entire classes of instruments (which Volcker seems happily willing to do) and loading the system down with so many new rules, regulations and definitions that compliance might be even more of an impossible task than it is today. The old cliché here is that the two groups that profit most from these situations are lawyers and accountants. That's undoubtedly true. But it also gives tremendous power (and the countervailing aversion to using it) to regulators. Ignored throughout this crisis is the dynamic, perhaps deeper than regulatory capture, between rule making (even of a deregulatory nature) and regulatory failure. The attempt to capture a complex and ever-changing reality through the net of rules is a loser's game and an invitation to look the other way.

Is this really the Volcker Plan? Well, he was standing there, though both the rhetoric and substance of the plan feel like it was massaged by many White House hands, from Timothy Geithner and Larry Summers to David Axelrod and his political crew. In the run-up to this announcement, Volcker, who the political reporters continue to insist had no stature in the administration despite reporting suggesting that Obama turned to him late last year, emphasized that the key fault line in banking was between those institutions that were vital parts of the payment system, presumably because of their exposure to the retail economy, and those that weren't, wholesale operations like Goldman Sachs and Morgan Stanley. That at least made sense. Volcker seemed concerned with TBTF, moral hazard and excessive pay, but he offered no mechanisms to defuse them. And he seemed confident that some new split between true banks and risk-taking enterprises was in the works. Based on details we have so far, and they're not only remarkably sketchy but about to be put through the congressional meat grinder, the kind of stable, safe, profitable financial system he envisioned is not a lot closer to reality. And that's not even wrestling with the question of this new system's effect on Main Street.

Robert Teitelman is editor in chief of The Deal.