Why Is The Volcker Rule Being Watered Down If Both Parties Support The Concept?

According to reports in both the Wall Street Journal and the Washington Post, the “Volcker rule” — which would bar banks from trading for their own benefit with federally insured deposits — is facing resistance in the Senate and will likely be watered down, if it’s included at all, in the regulatory reform proposal that Senate Banking Chairman Chris Dodd (D-CT) hopes to unveil next week. Dodd has been negotiating with Sen. Bob Corker (R-TN) in an attempt to craft a proposal that can garner bipartisan support, and the two have been saying that the Volcker rule is not being discussed much.

A few weeks ago, Dodd signaled that he may drop the Volcker rule outright as a way to pick up some Republican support for the wider bill. But interestingly, Republicans on the banking committee don’t seem to have any problem with the concept behind the Volcker rule:

– A spokesman for Sen. Richard Shelby (R-AL) said that Shelby “supports the spirit of the Volcker rule,” but he is “not convinced that the proposal itself is necessary.”

– Sen. Judd Gregg (R-NH) said that “conceptually” the Volcker rules makes sense, but that Treasury is “having trouble putting their arms around it.”

Why then, if both sides support the idea, would it be dropped? Instead of implementing the Volcker rule, the tide seems to be moving in favor of allowing regulators to ban proprietary trading at banks on a case-by-case basis, if the regulators deem that the trading is posing a threat to the health of a particular bank.

That approach might work if regulators are actually on their game, but the last crisis proved that regulators have a tendency to turn a blind eye to practices that lead to big bank profits. For instance, the Federal Reserve had the capability to regulate mortgage lending in the lead-up to the subprime crisis, but did nothing, while other regulators actively exempted firms from rules aimed at reining in their lending practices. Counting fully on diligent regulators can lead to catastrophe, especially if you have someone like President Bush appointing them, since he sought regulators who would be lax on the enforcement side.

This week, five former Treasury Secretaries endorsed the Volcker rule in a letter to the Wall Street Journal. “We fully understand that the restriction of proprietary activity by banks is only one element in comprehensive financial reform. It is, however, a key element in protecting our financial system and will assure that banks will give priority to their essential lending and depository responsibilities,” they wrote.

“For any reform to be effective, it is important that we go back to separating, in some function or other, the normal banking activities of commercial banks from the trading activities,’’ said W. Michael Blumenthal, who was Treasury Secretary under President Carter. “The mixing of those two has gotten us into trouble, and it’s important to fix it.” Former Citigroup CEO John Reed agreed, saying that “the industry should be compartmentalized so as to limit the propagation of failures.”

Yesterday, the White House pushed back on reports that it was open to watering down the Volcker rule. “We’re as committed to that now as we were on that day,” the White House press secretary, Robert Gibbs, said yesterday. “We’re not walking away from what the president outlined on the Volcker rule.” If that’s true, they might want to get the message to the Senate.