The ‘Volcker Rule’ as a modern-day Glass-Steagall

By John Authers, Investment editor , Financial Times 

Published: January 21 2010 19:44  

For Glass-Steagall in the 1930s, read the Volcker Rule for a new decade. Instead of the crude separation of commercial and investment banking, we will now see an equally crude split of the banking business from proprietary trading, hedge funds and private equity. 

Some salient points on Glass-Steagall are often missed. First, for decades, it worked. The US financial reforms of the 1930s helped to deliver decades of stable economic growth and reasonably stable growth in equity markets. 

Second, its very crudeness may have been the key to its success. A clear-cut if arbitrary division will be obeyed. Subtle tinkering with incentives can lead to “gaming the system”, as seen most blatantly in the Basel rules that inadvertently encouraged banks to charge into subprime mortgages.

A crude ban on proprietary trading may well be the best modern equivalent of the Glass-Steagall division.

The short-term stock market reaction was, inevitably, negative, with US stocks down about 2 per cent. But they were due for a correction after a long rally and this could have been much worse.

The most directly affected banks were down about 5 per cent, but as they have huge and profitable holdings in hedge funds, this again says little about the market’s judgment on the overall policy.

Longer term, history suggests that a reform along the lines of the Volcker rule could help shake world markets from their extreme tendency for booms and busts. The danger is that a fundamentally good idea must now be filtered through a dysfunctional US Congress in an election year.

This adds to a baffling array of medium-term risks. Traders are already worried about Chinese real estate and the Greek public sector. They must now keep an eye on every twist and turn this legislation takes in Congress. The exact policy that will emerge is ambiguous – and that will unambiguously stoke market volatility in the months ahead