“If you look at the crisis, most of the losses that were material for the weak institutions – and the strong, relative to capital – did not come from those [proprietary trading] activities.  They came overwhelmingly from what I think you can describe as classic extensions of credit.”

- Treasury Secretary Geithner, Sept. 10, 2009

On January 21^st, President Obama announced a proposal that would ban commercial banking companies from engaging in proprietary trading, hedge fund, or private equity activities.  The President called the proposal the “Volcker rule,” after former Federal Reserve Chairman Paul Volcker.  More recently, Senator Blanche Lincoln (D-AR), Chairman of the Senate Agriculture Committee, has passed out of the Committee legislation that would require banking companies to divest of their derivatives trading businesses.

A proper policy response to the financial crisis depends on an accurate diagnosis of the factors that contributed to it.  Trading – proprietary or otherwise – didn’t cause the financial crisis.  The Volcker rule and proposals that would ban banking companies from dealing in derivatives misdiagnose the causes of the crisis and, therefore, would needlessly undermine the international competitiveness of U.S. financial institutions, to the detriment of American businesses, consumers, savers, and investors.

• The financial crisis was not a “risky trading” crisis – it was a poor lending crisis.  The value of mortgage-backed securities plummeted in value not because they were traded, but because too many of the mortgages that backed those securities fell into foreclosure.  Policymakers should focus on fixing why that happened.

• At a September 10^th, 2009 hearing before the Congressional Oversight Panel, Treasury Secretary Timothy Geithner stated in response to a question about the role of proprietary trading in causing the financial crisis: “Most of the losses that were material for the weak institutions – and the strong, relative to capital – did not come from those [proprietary trading] activities.  They came overwhelmingly from what I think you can fairly describe as classic extensions of credit.”

• In an October 15, 2008 Op-Ed published in the Wall Street Journal, American Enterprise Institute fellow Peter Wallison agreed: “None of the investment banks that have gotten into trouble…were affiliated with commercial banks...[Moreover], the ability of…banks to diversify into non-banking activities has been a source of their strength.”

“Plain Vanilla” Lending is a Risky Activity

• A number of Senators have talked about protecting “plain vanilla banking” from “risky trading,” as if banking is lower risk or even riskless.  Not only does lending entail risk, lending – money out the door that banks hope will be paid back – is arguably the riskiest activity that any financial entity can engage in.

• 140 banks failed last year, the highest rate of failure since 1992.  56 banks have failed so far this year, an even faster pace of failure than last year.  Each of the 196 banks that have failed since January of 2009 failed because of loan losses – not one because of trading.

• In the history of finance, derivative dealing has brought down exactly one major financial institution – AIG – and that was not because of derivatives, per se, but because of inadequate controls, risk management, and clearing and settlement procedures.  By stark contrast, poor lending has led to the failure of thousands of banks and other financial institutions over the years.

Diversification of Revenues Help Make Banks More Stable

• Institutions that have a diverse mix of businesses – commercial banking, securities underwriting, and trading – performed best during the recent crisis.  JPMorgan Chase, Wells Fargo, and Bank of America served as the instrumentality of stability and recovery during the crisis by absorbing other failing institutions.  JPMorgan Chase absorbed Bear Stearns and Washington Mutual; Wells Fargo absorbed Wachovia; Bank of America absorbed Countrywide and Merrill Lynch.

• Trading activities don’t necessarily make banks more risky; in fact, they can help make banks less risky and more stable by diversifying the company’s activities and revenue streams.

Trading Restrictions Would Undermine Competitiveness of U.S. Institutions

• In February, European finance ministers indicated that “Volcker rule” restrictions would violate European Union universal banking laws.  Because Europe and much of the rest of the world are unlikely to ban banking companies from proprietary trading, hedge fund, and private equity activities, imposing the ban on U.S. institutions would amount to unilateral disarmament.

• Large corporate clients who depend on U.S. banks’ ability to provide the full range of financial products and services – loans, underwriting, trading, private equity, asset management – would likely turn to non-U.S. institutions if Congress bans banks from providing such services.

• At a February 2, 2010 hearing of the Senate Banking Committee, Chairman Chris Dodd (D-CT) stated: “For us to adopt this rule, without the rest of the international community…that makes this unworkable.”

• Undermining the competitive position of U.S. institutions will raise the cost of capital to U.S. businesses, corporations, and consumers, slowing economic growth and job creation.

Banning Banks’ Trading Activities Undermines Reform

• Because there is a robust market for the trading and market-making services provided by large banking companies – which are heavily regulated – banning banking companies from trading, hedge fund, and private equity activity will only drive such activities into unregulated aspects of the financial system, increasing systemic risk and undermining the fundamental objective of regulatory reform.

• All financial activities entail risk, but any financial activity – lending, trading, underwriting, insurance, asset management, etc. – is only as risky as the rigor and effectiveness of the risk management and control methodologies around that activity.

• Rather than arbitrarily prohibiting perfectly legitimate financial activities, a better and more appropriate role for government is to work with the financial industry to improve the quality and effectiveness of risk management, internal controls, corporate governance, and capitalization – and the quality of official supervision.