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The Telegraph - Volcker Rule is necessary to prevent bank failures turning into a crisis

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You heard it here first. On September 20 2008 The Daily Telegraph ran an article entitled "Strong medicine needed to cure ills of cheap money" in which I wrote: "I think US regulators should re-impose the Glass-Steagall Act."

Last week President Obama announced the Volcker Rule, named after Paul Volcker - a central banker of undoubted integrity and ability. This almost certainly means that in substance we are going to get a new Glass-Steagall Act.

Almost certainly because exactly how Volcker's Rule becomes law remains uncertain. It is likely to be subject to lobbying by vested interests and political horse-trading.

What is clear is that a measure like this is essential if we are to avert future crises such as the one we lived through in 2007-09.

Glass-Steagall was passed in 1933 in the aftermath of the Great Crash and Depression. It enforced a separation between commercial and investment banking in an effort to prevent a repetition of some of the practices which had helped to cause the Crash. It was repealed in 1999. Whatever its critics might say, the fact is that during its currency we did not experience a financial crisis on anything like the scale of the 1930s.

What is the Volcker Rule and why is it necessary? It is that deposit-taking banks will not be able to engage in proprietary trading or owning, investing in or sponsoring hedge funds or private equity funds.

Those who have opposed a new Glass-Steagall Act, and who will oppose the Volcker Rule, claim that such a restriction is unnecessary because allowing commercial banks (which take deposits and make loans) to engage in investment banking (now mainly trading in securities and instruments, often for their own account as principals) did not cause the financial crisis.

They have a point. The co-mingling of commercial and investment banking was not the root cause of the crisis which was essentially caused by many different forms of over leverage.

The essential point is that once the crisis had started, the fact that commercial banking had become co-mingled with investment banking – either because they were conducted by the same organisations, or because the investment banks such as Lehman Brothers were major trading counterparties of the commercial banks – meant that when the investment banking operations went bust they threatened to take commercial banking with them.

In a crisis, governments must always save major deposit-taking banks. Not to risks returning an economy to the age of barter.

If commercial banks have merged with or developed investment banking, or are reliant upon investment banks as major counterparties in their trading operations, the government will be forced to save those investment banking operations too. This has led to governments having to underwrite the liabilities of investment banks which are difficult or even impossible for them to fund.

In the coming months we will hear arguments about why the Volcker Rule is unnecessary. We will be told, as Lord Turner, chairman of the Financial Services Authority, suggests, that the same result can be achieved via new capital rules that could generate an "internal Glass-Steagall" by forcing banks to hold more capital and more expensive funding against investment banking operations.

Sadly, as the Bank of England Governor Mervyn King has pointed out, no amount of new regulation will prevent bank failures. Such faith in internal controls is touching after the experience of the control of conflicts of interest via the Chinese walls which were introduced at Big Bang.

Something like the Volcker Rule is required to prevent such failures turning into a crisis which burdens citizens with the unsupportable cost of bailing out speculative trading operations.

We will also hear that the separation of commercial and investment banking is too difficult, a term also used by Lord Turner in his report on the crisis.

As John Kay remarked in his report on "Narrow banking", if regulators can separate the generation of electricity from its distribution they can certainly do so with investment and commercial banking. The suggestion that banking is more complex than the physics and economics of electricity is risible.

Above all, these objections are the equivalent of arguing that the introduction of seat belts and air bags in cars is unnecessary because a way can be found to prevent accidents. The fact is that car crashes, like bank failures, will always be with us. The secret is to prevent them becoming fatal.

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Terry Smith 

The Telegraph