Last Thursday, without any fanfare, the Office of the Comptroller of the Currency released the economic analysis for the Volcker Rule. The timing-approximately three months after the OCC and its fellow regulators released the final rule-and the substance of the analysis are troubling. Financial regulators' failure to conduct and use thorough economic analysis in their decisionmaking means that they are reshaping our post-crisis financial markets without critical information about whether new rules will do more harm than good.
The Volcker Rule, which prohibits banks from engaging in proprietary trading and associating with hedge funds and other covered funds, was a controversial part of Dodd-Frank. The statutory mandate was aimed at addressing understandable concerns about government-subsidized bank risk-taking. But the Volcker Rule quickly proved to be an extremely complex implementation project, and one that poses risks of its own to financial market functioning.
When regulators adopted the Volcker Rule in December of last year, the draft they posted on the Internet included a hyperlink that promised eventually to house the OCC's regulatory impact analysis." Until last week, the link did not work. The fact that the analysis was not available when the rule was adopted is an indication that the analysis was a check-the-box exercise rather than a project undertaken to inform the rulemaking. Common sense and standard administrative practice dictate that a regulatory impact analysis should be conducted before a rule is crafted. Only then can it help regulators pinpoint the problem they are trying to solve, different potential solutions, and the costs and benefits of each.
In the case of the Volcker Rule, regulators wrongly assume that Congress exempted them from having to do such an analysis as part of writing the rule. At a congressional hearing last month, Federal Reserve Chair Yellen appeared flustered by Rep. Scott Garrett's question about whether a cost-benefit analysis was done for the Volcker Rule. She explained that "in essence, the decision about the costs and benefits of putting those restrictions in place were decided by Congress taking account of what the likely costs and benefits would be, and our job has been to implement it." Congressional analysis, however, seemed to be rooted primarily in warnings from the rule's namesake that "if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you." Congress did not carefully consider the problem at hand and alternative solutions.
The regulators' failure to explore the rule's economic consequences is particularly worrisome given what the OCC found. The OCC's analysis is rather thin, reliant on questionable economics, and (perhaps following Congress's lead) padded with quotes from Paul Volcker. Nevertheless, it identifies a number of potentially serious unintended consequences of the rule. It estimated annual costs of between $412 million and $4.3 billion, a range that-because of some fancy analytical footwork-excludes the rule's indirect costs.
Direct costs, such as compliance costs and lost market value from prohibited investments, are meaningful, but indirect costs could be even more important. As the OCC explains, the effect on market liquidity could be dramatic enough to drive up investors' trading costs. The rule's effects could be felt most heavily "when demand for liquidity is at its highest." The analysis downplayed liquidity costs by arguing that too much liquidity is bad for markets. The OCC highlighted the rule's positive effects on safety and soundness, but a footnote acknowledges that some academic research suggests that the Volcker Rule increases the likelihood that banks will default. The analysis also noted that the rule could shift risk-taking to products-such as those guaranteed by Fannie Mae and Freddie Mac-that are exempted by the rule.
Dodd-Frank directed regulators to dramatically change the way financial markets are regulated, and agencies are making these changes without first informing themselves of the consequences of their actions. The Volcker Rule's after-the-fact analysis is just the latest illustration of this troubling trend.