Monday, February 20, 2012

The Volcker Rule is not going to bring your house back

Got a great deal of hate mail lately on the post entitled Regulate it all, ask questions later. Many want to see solid research that would point to potential pitfalls of the so-called Volcker Rule. Otherwise they will fully support this regulation. Much has been written on the subject, but a recent paper by Darrell Duffie of Stanford, provides support to that Sober Look post.

Duffie draws two conclusions from his work:
1. "Over the years during which the financial industry adjusts to the Volcker Rule, investors would experience higher market execution costs and delays. Prices would be more volatile in the face of supply and demand shocks. This loss of market liquidity would also entail a loss of price discovery and higher costs of financing for homeowners, municipalities, and businesses."

2. "The financial industry would eventually adjust through a signi cant migration of market making to the outside of the regulated bank sector. This would have unpredictable and potentially important adverse consequences for financial stability."
As an example of flaws in the proposed regulation (among many in the paper), take a look at the chart below that shows the average return for stocks over time after they have been been removed from the S&P500 index. Typically as index mutual funds, ETFs, and other index linked investment programs (the AUM of these is in the hundreds of billions) are forced to sell a stock, the market makers step in for large blocks of shares. The dealers involved in the stock will make a profit over time as the newly excluded stock recovers, but they need the ability to take risk by holding the stock over a period. If the dealers are no longer there to make markets in these shares, the stock would crater, ultimately disrupting the market. And no, none of the other players, including algo traders, hedge funds, etc. will generally be willing to step in for such large blocks of shares. Since they are not market makers, they are not obligated to show a bid. That disruption hurts the non-index investors and the company itself.

Average cumulative returns for deleted S&P 500 stocks (Source: Darrell Duffie - 2010a).

Ultimately the answer to the banking crisis is in the improved overall capitalization and strengthened bank liquidity positions. The Volcker Rule, particularly in its current form is not the answer, because it has never been about market making. So before writing another hate mail on how you lost your house and how the Volcker Rule would have prevented it, read the paper. A little bit of knowledge will go a long way.


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