Senator Chris Dodd’s financial-regulatory bill includes some of what the press calls the “Volcker Rule” (p478): banning FDIC-insured banks and their affiliates or parent companies from what’s known as “proprietary trading” or betting supposedly safe banking deposits on speculative market activities.
Except! Dodd includes a huge loophole for state and local governments.So, your staid or not-so-staid old bank won’t be able to make intense, highly leveraged short-term bets on, say, corporate debt. But it will be able to make such bets in areas to be exempt from the rule: U.S. Treasury securities, Fannie Mae securities, and the debt of “any State or any political subdivision of a State” (like New York City or the MTA).
Why the exception? It’s simple. The feds want to ensure that demand remains high for these securities, so that borrowers can continue to access markets at low rates. What better way to do that than to ban banks’ prop trading from almost everything else — forcing them to go to Treasury and muni-market debt to make valuable short-term trading profits?
Trading this debt can be risky, of course. Short-term traders have periodically been burned on short-term bets on Fannie securities going back 20 years now. And inviting banks to do such profit-churning trading exclusively in certain markets makes those markets, including the muni markets, riskier from the point of view of their traditional buy-and-hold investors, who might not like to see big jumps and drops in price depending on what exuberant or panicked markets are doing at any given moment.