Volcker Says Prop Trading Poses Bank Conflicts of Interest

Former Federal Reserve Chairman Paul Volcker, commenting in support of the Dodd-Frank Act rule that bears his name, said it is impossible for banks to handle the potential customer conflicts presented by trading activities.

“Imposing on those essential banking functions a system of highly rewarded –- very highly rewarded -– impersonal trading dismissive of client relationships presents cultural conflicts that are hard -– I think really impossible -– to successfully reconcile within a single institution,” Volcker said today in remarks prepared for a Senate Banking subcommittee hearing in Washington.

The Senate panel met to discuss risks posed to the by the size and interconnectedness of financial firms. Lawmakers and regulators have been looking at ways to reduce risk in the financial system since the 2008 economic crisis, when Wall Street’s largest banks required a $700 billion taxpayer bailout.

Senator Sherrod Brown, the Ohio Democrat who leads the Financial Institutions subcommittee, introduced legislation today that would cap the size of banks, limiting to 10 percent the share of total deposits and total liabilities any one could hold. It also would limit the size of non-deposit liabilities at banks to 2 percent of U.S. gross domestic product.

“It’s vital we take the necessary steps sooner rather than later to end government policies that support and encourage large complex institutions,” Brown said today.

Previously Rejected

Brown’s bill is similar to an amendment he introduced in 2010 during debate over what became the Dodd-Frank Act. That measure was rejected in a Senate floor vote.

Volcker, who spent much of the hearing answering questions about his intent for the proprietary trading ban, said while he would prefer a less concentrated banking system, he can “live with” the current size of U.S. financial institutions.

The former Fed chairman, who championed the proprietary trading ban while serving as an adviser to President Barack Obama, said it is an “important step” to address conflicts of interest, as well as “compensation practices and, more broadly, the culture of banking institutions.”

The Volcker rule is intended to reduce the chances that banks will put federally insured depositors’ money at risk. Banks including Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co. (JPM) and Morgan Stanley (MS) have argued that it is so broad and poorly defined it will force them to shed business lines and could actually increase risks for their clients.

“I think they are making it overly complicated,” Senator Bob Corker, a Tennessee Republican, said today of regulators’ efforts to implement the rule.

October Proposal

The Fed, Securities and Exchange Commission and Federal Deposit Insurance Corp. are among the regulators drafting the final rule. The initial 298-page proposal was released in October and criticized by groups on both sides of the issue. Regulators last month announced that banks would have a “full two-year period” to implement the new rule, which is scheduled to go into effect on July 21.

After his testimony, Volcker said lobbying against the rule was playing a role in adding to its complexity.

“What I would do is make clear what the purpose is, have a good sense of metrics afterwards and make sure the management of the bank understood the purposes,” he told reporters outside of the hearing room. “They’re not dummies and they know what proprietary trading is, and their control systems reflect that. If that’s all OK, then let them go at it and we’ll review their activities ex post.”

Money-Market Funds

Volcker also said during the hearing that regulators should consider structural changes to money-market funds and impose stronger capital requirements and oversight.

Concern over money funds, once seen as among the safest of investments, grew after the September 2008 collapse of the $62.5 billion Reserve Primary Fund, which triggered a broader run that contributed to a freeze in global financial markets. The SEC adopted rules in 2010 that introduced liquidity minimums, average maturity limits and new disclosure requirements.

Money-market funds have fought any additional regulation. Christopher Donahue, the chief executive officer of Pittsburgh- based Federated Investors Inc. (FII), the third-biggest U.S. money- fund provider, said Jan. 27 that his firm would sue the SEC if it went forward with a proposed rule.

To contact the reporter on this story: Phil Mattingly in Washington at pmattingly@bloomberg.net

To contact the editor responsible for this story: Maura Reynolds at mreynolds34@bloomberg.net