February 20 February 26,2012 Bloomberg BusinessWeek

Bloomberg Last-Minute Fixes to the Volcker Rule A Budget Band-Aid on Corporate Taxes
A Simpler, More Effective Volcker Rule

The Volcker Rule is facing heavy criticism as regulators prepare a final version. In recent days big banks, investment managers, and even the governments of Germany, Japan, and Britain have lamented what they see as the rule's adverse effects. Their primary complaint relates to a section that allows banks to engage in the business known as market making. This useful activity, which helps customers buy or sell financial instruments, is dominated by a handful of banks. It can be difficult to distinguish from proprietary trading because both tend to involve buying and selling for the bank's own account. Market makers do so in anticipation of clients' needs. Prop traders do so solely to make bets with shareholders' and creditors' money. The rule's critics worry that aggressive efforts to eliminate proprietary trading will complicate market making, leading banks to charge more for the service or pull out of the business entirely. This, in turn, could prompt investors to demand a higher return to compensate for the extra difficulty in making trades, thus increasing borrowing costs for governments and companies. One study, commissioned by afinancial-industrytrade group, estimates that the decreased liquidity-that is, the impaired ability to trade quickly and inexpensively-could add as much as $43 billion a year in borrowing costs for U.S. corporations while knocking as much as $315 billion ofthe value of existing corporate bonds. There are reasons to question the validity of such analyses. First, they assume that if the rule puts a chill on market making, the structure of the market would remain the same. Unlikely. If big banks such as JPMorgan Chase and Citigroup were to pull out or to charge more, smaller dealers that aren't banks, such as Jeflferies and Cantor Fitzgerald, would probably step in tofillat least part of the void. Second, the Volcker Rule's critics talk as if liquidity is an unmitigated good.

Questionable. Economists from Keynes to Larry Summers-and more recently, Adair Turner, chairman of Britain's Financial Services Authority-suggest that higher transaction costs could be beneficial because they favor long-term investment over short-term speculative trading. One genuine danger of the Volcker Rule, as currently written, is that it could impose requirements that nobody can reasonably follow or enforce. It offers, for example, 17 quantitative measures by which regulators will assess whether banks' market-making activities constitute proprietary trading. Even a genuine market-making operation might look proprietary by some measures. As a result, regulators will be drawn into debates with banks about which indicators really matter. As they craft thefinalrule, regulators should pare down the measures to the few that are most relevant. One to consider keeping is how much a bank's marketmaking desk could lose in various worstcase scenarios. As long as the value at risk is no larger than it was before the financial crisis, chances are the bank isn't adding any proprietary trading to its market-making activities. It'll be difficult tofinda version of the Volcker Rule that executives at the largest U.S. banks will love. But as long as it makes the economy more resilient to financial shocks without unduly gumming up markets, it will be good for America.
Kicking Corporate Taxes Down the Road

The U.S. has one of the highest corporate tax rates in the world, topping out at 35 percent. That rate puts U.S. companies at a competitive disadvantage to trading partners, whose effective taxes are, on average, lower than 30 percent. A higher corporate tax rate makes it cheaper to do business overseas, encouraging companies to send jobs abroad. What's more, higher taxes are largely passed on to U.S. workers and consumers in smaller paychecks and higher prices. The Obama administration claims

to understand this. Yet its latest budget, which projects a $901 billion deficit in fiscal 2013, perpetuates the clumsy way the U.S. has tried for decades to reduce the overall tax rate with ever more credits and deductions. The budget encourages manufacturers, for example, to invest in the U.S. by proposing new deductions for companies that stay onshore and new credits for those investing in hard-hit communities. It would also impose a minimum tax on overseas earnings and make it harder for companies to defer taxes on overseas profits. In total. President Obama would spend more than $120 billion over the next decade on tax breaks primarily for manufacturing. The President would partially pay for this by ending a tax deduction on domestic oil and gas production, saving almost $12 billion over a decade. That's a good thing; such companies are highly profitable and able to attract capital on their own. Obama would apply those funds toward the more generous tax deduction for manufacturers and would even double the deduction to 18 percent for high-tech manufacturers. That could raise all sorts of questions about what qualifies as high tech: Would companies that make iPad accessories or the packaging they come in make the cut? The bigger problem is that tax credits rarely drive corporate behavior, especially decisions as important as a facility's location. Economists say other factors, including wages, availability of skilled labor, and proximity to customers, carry more weight and that the Obama tax changes would probably be marginal at best. The tax proposals in the White House's budget seem designed more for political advantage than to put forward the best policy. Obama officials hint that a corporate tax overhaul may come later this year-something they've predicted in the past, only to back away. Before asking voters to give him a second term, Obama needs to show how he wouldfixa fractured system.

>To readAl Hunt on Rick Santorum and Simon Johnson on the intellectual debate over liquidity rules, go to: Bloomberg.com/view

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