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Morici: Volcker Rule Arrives as Hidden Gem in Dodd Frank

NEW YORK (TheStreet) -- U.S. regulators are finally implementing the Volcker Rule, and it may prove to be the hidden jewel in the Dodd-Frank financial reforms.

The rule limits bank purchases of stocks, bonds, currency, commodities, and derivatives -- contracts that bet on movements in the prices of assets -- with their own money, which also put their federally insured deposits at risk.

Financial behemoths such as JPMorgan Chase(JPM) earn huge profits from such proprietary trading. Those profits help pay huge bonuses for traders and also create great jobs for many ordinary Americans. Unfortunately, trading distracts attention from the ordinary business of taking deposits and lending money to small businesses and homeowners.

It sounds reasonable. Encourage banks to be banks again by pushing them toward lending by prohibiting trading, essentially making bets with deposits ultimately guaranteed by taxpayers.

Must Read: Salmon: The $5 Trillion Dilemma Facing Banking Regulators

During the financial crisis, however, securities trading didn't get the big Wall Street banks in trouble. In fact, the profits from trading kept many solvent when mortgages failed and later when the banks paid big fines for misrepresenting mortgages sold to institutional investors.

Prior to the crisis, banks made loans to finance homes buyers couldn't afford, and then bundled mortgages into bonds to sell to pension funds, insurance companies and other investors. When investors figured out many loans would fail, banks got stuck holding too many bad loans and mortgage-backed securities.

Once some mortgages failed, foreclosures snowballed and housing prices collapsed. </>Other complex arrangements, such as buying and selling derivatives intended to insure against too many mortgages failing, contributed mightily to the morass, but it wasn't JPMorgan trading in foreign exchange or Goldman Sachs(GS) buying and selling aluminum futures that caused the collapse. That trading stayed profitable, even for Citigroup(C), which headed the list of basket-case banks Uncle Sam had to rescue.

Today's big Wall Street banks are not your grandfather's banks. They are financial conglomerates that are both old-fashioned commercial banks and investment banks that help corporations sell new stock and bonds; brokerage houses that help the little guy invest; wealth managers for the portfolios of families rich enough to be corporations; and creators of markets in municipal bonds, foreign exchange and other assets where no large public market exists or is sufficient.

Investment bankers learn a lot from those activities, and often buy and sell assets with their own money to profit. That makes markets function better and is a source of profits so huge that banks don't have enough interest in making loans, especially to smaller businesses.

Unfortunately, Dodd Frank put such onerous and costly restrictions on ordinary bank lending that small-town and regional banks have been selling out to larger brethren, and a handful of large big city financial conglomerates now control more than half of all U.S. bank deposits. As a result, many smaller businesses have lost their traditional sources of bank credit, hampering their ability to invest and create jobs.

Before the 1933 Glass-Steagall Act was repealed by Congress and President Clinton, investment banking was kept separate from federally insured commercial banking. And that's what needs to happen again, and the Volcker Rule could prompt just that.

As difficult as it may be for JPMorgan Chase CEO Jamie Dimon to accept, now that the Volcker Rule makes it illegal for entities owning a commercial bank to engage in proprietary trading, it may be the best business decision for his firm to spin off its bank.

Chase Bank can stand on its own, and would better serve the economy as a bank focused on taking deposits, making loans and offering such consumer financial services as life insurance, retail brokerage services and trust activities.

Let JPMorgan be independent and wheel and deal, and in the process create wealth and jobs like few businesses other than those in Hollywood and the Silicon Valley can, but not with a government guarantee of its solvency. If it gets in over its head, let it fail.

At the time of publication, the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Professor Peter Morici, of the Robert H. Smith School of Business at the University of Maryland, is a recognized expert on economic policy and international economics. Prior to joining the university, he served as director of the Office of Economics at the U.S. International Trade Commission. He is the author of 18 books and monographs and has published widely in leading public policy and business journals, including the Harvard Business Review and Foreign Policy. Morici has lectured and offered executive programs at more than 100 institutions, including Columbia University, the Harvard Business School and Oxford University. His views are frequently featured on CNN, CBS, BBC, FOX, ABC, CNBC, NPR, NPB and national broadcast networks around the world.

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