The Volcker Rule

Former Fed Chairman Paul Volcker suggested what has come to be called the Volcker Rule.

I am with Anat Admati and Martin Hellwig in strongly preferring tougher equity requirements on the liability side of the balance sheet that make sure banks and other financial firms are investing their own shareholder’s money to tight restrictions on the asset side like the Volcker rule. But given where the discussion is, I think the Volcker rule is a net plus. The Volcker rule can always be loosened later in exchange for higher equity requirements. The stronger the liability-side rules (high equity or “capital” requirements) the more financial firms can innovate on the asset side without putting the economy in danger, or putting taxpayers on the hook. The value of that innovation is one reason I think equity requirements are so much superior. Of course, there have to be *some* asset-side rules, but they only have to rule out quite extreme positions if the equity requirement is at 50%, as I recommended here:

Anat Admati, Martin Hellwig and John Cochrane on Bank Capital Requirements.

The reason common equity is such a good funding mechanism for financial stability is that stock prices go up and down all the time and no one is likely to be deceived by a claim that stocks are totally safe. By contrast, almost all forms of debt have built into them some relatively sudden transition from looking fairly safe to looking very scary when things go south. Stocks don’t have that sudden transition because they always look at least a little scary.