The regulation that would implement the so-called “Volcker Rule” contained no surprises. It has all the deficiencies of the original Dodd-Frank language, which would prohibit “banking entities” from engaging in proprietary trading. A “banking entity” is any company under the control of a firm that also controls a bank—in other words, a bank holding company (BHC). Thus, although the supporters of Dodd-Frank and the ban on prop trading assert that banks should not be using depositors’ FDIC-insured funds to engage in risky trading activities, they fail to mention that BHCs and their nonbank subsidiaries have no access to depositors’ funds. The only funds they use are those they earn, raise in the form of equity, or borrow. Since regulations make it very onerous to borrow from a bank that any BHC controls, that is seldom done. And when it is done, it has to be at arms’ length rates and collateralized, usually with U.S. government securities.
So the Dodd-Frank provision is simply another example of the act’s intent to exact penalties from U.S. banks for (allegedly) “causing the financial crisis.”
Ironically, however, short-sighted legislation and regulation like this will be responsible for the next banking crisis, because it will deprive BHCs of another perfectly legitimate source of profits and thus weaken their ability to support their subsidiary banks with additional capital. More important, by limiting the permissible range of activities for BHCs, it restricts their ability to diversify, and thus weakens them for the future.
This lack of diversification is apparent when one looks at the increasing concentration of banks and bank holding company lending to the real estate business. This is particularly perilous because commercial and residential real estate is notoriously volatile, and the concentration of lending in these areas will make banking organizations vulnerable to a crisis whenever there is trouble in the real estate business—historically an all-too-frequent occurrence.
In 2008, before the financial crisis, more than 55 percent of bank lending was to real estate or real estate-related activities—up from less than 25 percent in 1964. This dangerous concentration in real estate lending is the result of a change in the nature of the financial markets since 1965. At that time, banks had a robust business in lending to corporations of all kinds, but the growth of the securities markets made it possible for corporations to finance themselves through public offerings—not only through long-term bonds but also medium-term notes and short-term commercial paper.
Left alone, banking organizations would have had the flexibility to respond to this change, but they were confined by laws and regulations. Not until 1999, when Congress modified the Glass-Steagall Act to permit bank holding companies to control securities dealers, were bank holding companies (but not banks themselves) able to engage fully in the securities business. The Dodd-Frank Act now takes back most of that flexibility and consigns banking organizations to lending—but only to those firms, like real estate developers, that cannot easily raise their funds in the securities markets.
In this, the destructive policies of Dodd-Frank Act, of which the Volcker Rule is just one more example, have planted the seeds of a banking crisis in the future.