Last week Fed Chairman Ben Bernanke announced a delay in the implementation of the
Volcker Rule, news that should make investment banks give a big sigh of relief.
Everyone knows the role that risky asset backed securities played in financial crisis. What's less clear to some people is how the collapse of the market for these exotic instruments almost brought down our banking system.
The problem was that banks were trading in these securities for their own benefit. That is, they weren't buying them on behalf of customers, they were acting as investors themselves.
And when enormous banks make really bad investment decisions, they can bring the financial system down with them. Whether or not you liked the idea of taxpayer bailouts of the big banks, they happened because regulators were afraid that the collapse of the big banks would bring the whole system down.
Unfortunately the bailout also taught the investment banks a valuable lesson. They could make massive, risky bets-- and if they were profitable, they could keep the money. If they failed, taxpayers would pick up the tab. That's a recipe for disaster.
The Volcker Rule, part of the Dodd Frank law passed in 2010, was an attempt to prevent investment banks from taking advantage of their taxpayer safety net by engaging in risky trading. It is a simple idea- a ban on proprietary trading by banks that have the backing of taxpayers.
Not surprisingly, the ban is very unpopular with banks, who have been fighting it tooth and nail. Proprietary or "Prop" trading is often their most profitable business. When the Volcker Rule goes into effect, Goldman Sachs and Morgan Stanley, which have already seen a decline in profitability, could take a hard hit.
While the delay puts off the day of reckoning for the investment banks, the story isn't over yet, as the banks and shareholder advocates continue to wrestle over how the rule should be implemented.