Volcker to Press Lawmakers to Restrict Activities of Big Banks

BY Carolyn O'Hara  February 2, 2010 at 11:34 AM EST

White House adviser and former Fed chairman Paul Volcker will testify before the Senate Banking Committee Tuesday and press its members to restrict the activities of big banks and limit their overall size.

In making the case for what’s become known as the Volcker Rule — preventing commercial banks from engaging in proprietary trading — Volcker will say that such restrictions will limit risk-taking by big banks, deal with the issue of “too big to fail” and help remove the issue of moral hazard associated with government bailouts.

Broadly defined, proprietary trading occurs when a bank makes investments and trades solely with its own money — as opposed to customers’ money — solely for its own profit.

Volcker has argued that such speculative activity increases risks and helped bring about the financial crisis. According to his prepared testimony for Tuesday:

When the bank itself is a “customer”, i.e., it is trading for its own account, it will almost inevitably find itself, consciously or inadvertently, acting at cross purposes to the interests of an unrelated commercial customer of a bank.

But how to precisely define proprietary trading in a way that prevents banks from easily skirting the rule has become a topic of debate on Wall Street and is likely to be addressed at Tuesday’s hearing.

Volcker also plans to make the case that hedge funds and private equity funds should be allowed to fail without expectation of help from the government.

Talk of the Volcker rule — and how to best oppose it — was unsurprisingly a popular topic of conversation among bank CEOs at the World Economic Forum in Davos last week.

According to Aaron Ross Sorkin in the New York Times:

As Mr. Diamond [chief executive of Barclays Capital] made his case to the Davos audience on Wednesday, he said, “It’s very, very difficult to think that we can differentiate between the risk banks take in the normal course of business for their clients and customers, and proprietary trading.”

A senior banker put it to me more bluntly: “I can find a way to say that virtually any trade we make is somehow related to serving one of our clients. They can go ahead and impose the rule on Friday, and I can assure you that by Monday, we’ll find a way around it. Nothing will change unless the definition is ironclad.”

Paul Solman recently sat down with economist George Shultz to talk about what to do about “too big to fail.” Shultz’s answer? Take a lesson from Christmas tree light manufacturers.