The House Financial Services Committee will hold two hearings this week on Dodd-Frank implementation--the first on derivatives and the second on the Volcker Rule, which limits banks proprietary trading and private fund activities. Both portions of Dodd-Frank have proved more difficult to implement than their Pollyannish proponents envisioned. The Commodity Futures Trading Commission came out of the gate quickly with its derivatives rules, but market realities have forced it to moderate the pace of the implementation process through a series of staff guidance documents. The Volcker Rule regulators have issued a proposal, but apparent inter-regulator struggles have delayed a final rule.
Wednesday's derivatives hearing is likely to focus on technical implementation issues, but Thursday's Volcker hearing offers an opportunity to raise more fundamental questions. Is the Volcker Rule the right way to address the government's decision to stand behind so many of the banking system's liabilities? Are regulators capable of preventing bankers from engaging in the risky behavior that deposit insurance encourages them to pursue, or is the market better able to police and punish bankers that take on excessive risk? Will the Volcker Rule simply reinforce dangerous tendencies for markets to lean on regulators to make risk determinations and taxpayers to bear the associated losses?
Such inquiries at the Volcker hearing would encourage a productive dialogue on how the market can be harnessed to carry out the discipline that regulators struggle so hard to exercise. There are feasible options that would cause shareholders and creditors--rather than regulators--of financial institutions to pay more attention to risks those entities are taking on. Placing reasonable limits on deposit insurance, exposing shareholders of financial institutions to losses (beyond having their equity wiped out) if their entities fail, increasing transparency of banks' portfolios, making banks' supervisory ratings public, and introducing contingent capital to force creditors to monitor banks are several options that should be considered. Financial institutions, scared of alienating potential creditors and shareholders, would respond to these measures by being more careful--the result the Volcker Rule is trying to achieve.