A new study from economists Arnoud Boot at the University of Amsterdam and Lev Ratnovski at the International Monetary Fund shows that banks trade too much, so new regulation is necessary to keep the world’s biggest banks from posing a risk to the entire global economy.
Boot and Ratnovski’s study found that excess capital generated from traditional banking activities allows banks to gamble on risky trading, and since the biggest banks have more capital, they gamble even more. This causes a diversion of capital toward trading that adds instability to financial markets.
And because banks will always engage in such trading, the best way to prevent it is through regulation like the Volcker Rule, a provision in the 2010 Dodd-Frank Wall Street Reform Act that would prevent banks from making risky trades with taxpayer backed dollars:
Our results highlight the dynamic problems in universal banking and sheds light on the desirability of restricting bank activities of the type that were recently proposed by the Volcker rule in the U.S. and the Vickers report in the UK.
Originally one of the strongest provisions contained in Dodd-Frank, the Volcker Rule was watered down by Republican senators and bank lobbyists so much its namesake Paul Volcker is no longer satisfied with it. But recent trading losses like the one sustained in JP Morgan Chase’s “London Whale” trade have caused the rule’s authors to urge regulators to strengthen it before it is fully implemented.
According to Boot and Ratnovski, banks that are allowed to engage in risky trading will always do so because it allows them to gain larger profits. Because of this, the supermarket banking model — in which banks both lend and act as investing houses — “is no longer sustainable.” That’s a view shared by many former bankers, including former Citigroup CEO Sandy Weill, who helped pioneer the expansion of banking institutions into trading and other services.