The fate of the Dodd-Frank Act’s ban on banks trading for their own accounts -- one of the final pieces of the U.S. effort to prevent a repeat of the 2008 financial crisis -- may rest with a cluster of economists at the Securities and Exchange Commission.
The agency’s 50 economists are attempting to calculate the costs and benefits of the so-called Volcker rule, a linchpin of the financial overhaul that would curb the kind of high-stakes proprietary trading that could lead to crippling losses or bailouts at banks like JPMorgan Chase & Co. (JPM) or Citigroup Inc. (C)
Court challenges that overturned other Dodd-Frank regulations because of faulty cost-benefit analysis have increased pressure on the SEC economists, led by Craig M. Lewis, a veteran finance professor on leave from Vanderbilt University. Their work may determine whether the rule could withstand a similar lawsuit -- an option banks and trade groups say is under consideration.
The economists are racing the clock: Regulators are under pressure from President Barack Obama and Treasury Secretary Jacob J. Lew to finish the rule in the next three months. At a recent meeting, Lew gave the heads of the five agencies drafting the rule a series of deadlines designed to make sure the government meets the year-end target, according to a person briefed on the meeting who asked not to be identified because it wasn’t public.
“Hell or high water, we’re getting it done,” Comptroller of the Currency Thomas Curry said in an interview.
The agencies -- the Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, Commodity Futures Trading Commission and SEC -- have reached agreement on key issues, including the definitions of activities like market-making and portfolio hedging, and are now working on the final text, according to three people familiar with the process who declined to provide details.
The rule, named for former Federal Reserve chairman Paul Volcker, is one of the remaining pieces of the overhaul of U.S. financial regulation enshrined in Dodd-Frank, which was signed into law by Obama in 2010. It is aimed at preventing banks that hold federally insured customer deposits from engaging in the kind of speculative trading -- with their own capital -- that before Dodd-Frank would have led to a bank failure and government bailout.
Prior to the financial crisis, proprietary trading was a money-maker for banks, and during the crisis, it contributed to losses. The six largest banks’ standalone proprietary-trading desks reported losses in five quarters in 2007 and 2008, losing a combined $15.8 billion, according to a 2011 report from the Government Accountability Office.
Profits are at stake in the final wording of the rule. Standard and Poor’s has estimated that Volcker could sap combined profits at the eight largest U.S. banks by between $2 billion and $10 billion a year, depending on details of the final provisions.
Obama called the regulators to the White House last month to “share his sense of urgency” that Dodd-Frank rules including Volcker be completed soon, according to deputy White House press secretary Josh Earnest.
The message was amplified by Lew on Sept. 10 when he convened a private meeting at the Treasury Department of the agency heads during which he laid out a timetable designed to ensure completion by the end of the year, according to the person briefed on the meeting.
“Treasury wants this done” and is “cracking heads” to get there, said Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics.
Wall Street banks face a July 21, 2014, deadline for complying with Volcker, which must be formally adopted by all five agencies before it takes effect. If regulators miss their 2013 goal, banks will have three weeks to file for individual extensions, a process expected to cause more delays.
In the two years since the first draft was released, the text may triple in size reach 1,000 pages, according to one person familiar with the draft. The initial proposal posed hundreds of questions to solicit input from affected banks, and more than 18,000 letters flooded in. Reviewing all those comments also slowed the rule-writing.
The economics unit -- officially known as the Division of Economic and Risk Analysis -- was established by former SEC Chairman Mary Schapiro in 2009 to help commissioners gauge the impact of new rules as well as spot the kind of emerging risks exposed in the credit crisis the year before. The office has doubled its staff as it’s taken on the task of analyzing dozens of proposed rules under Dodd-Frank. Lewis, an expert in equity analyst behavior and corporate finance policy, took over the helm in 2010.
Along with tallying a rule’s costs, the agency’s official guidance directs the economists to quantify its benefits including crisis-related goals such as reducing “excessive risk-taking or actions that are otherwise characterized by moral hazard.”
Part of the difficulty the agency faces, Petrou said, is pinning numbers on nebulous concepts.
“The key to effective cost-benefit analysis is assessing real costs -- i.e., to efficiency, profitability, liquidity -- not to focus on the easy ones like how many hours it will take to file all the requisite forms,” she said in an e-mail. “The benefits are similarly qualitative -- the reduced risk of systemic failure, market benefits of new competition, etc. That’s what makes these cost-benefit analyses so tricky -- there are few hard numbers anywhere and regulators have yet to develop a robust methodology for more qualitative cost-benefit assessments that will stand up in court.”
Banks and financial firms that opposed elements of Dodd-Frank have successfully argued in court that some of the agency’s previous cost-benefit analyses were flawed. The first attack overturned the so-called proxy access provision in 2011, and another forced the SEC to announce earlier this month that it would re-write a Dodd-Frank disclosure rule.
The financial industry has signaled that the cost-benefit analysis accompanying the Volcker rule will get similar sharp scrutiny. Trade groups including the Securities Industry and Financial Markets Association, the Clearing House, the Financial Services Roundtable and the American Bankers Association sent a letter to regulators in February 2012 urging them to conduct a “rigorous” cost-benefit analysis of Volcker. The U.S. Chamber of Commerce, one of the litigants in the proxy-access case, wrote that errors “may lead to the promulgation of a flawed final rule that has severe, unintended consequences for capital formation.”
“It is incumbent on the regulators to get the final rule buttoned down correctly and implemented in a smart way to avoid litigation,” said Tom Quaadman, vice president of the Chamber’s Center for Capital Markets Competitiveness.
H. Rodgin Cohen, a lawyer at Sullivan & Cromwell LLP who represents large banks, said that whatever its final provisions, regulators should expect the Volcker rule to draw a legal challenge.
“Clearly there have been several cases recently where the regulatory agencies have been successfully sued,” Cohen said in an interview. “I do not put that totally beyond the realm here.”
At least one cost-benefit analysis was decided in favor of the regulator. In 2012, the CFTC, the main U.S. derivatives regulator, prevailed in a lawsuit over a Dodd-Frank rule, with the court finding its analysis sufficient.
While Volcker’s crosshairs are fixed on the very largest U.S. banks, it could affect operations at nearly all 7,000 U.S. depository banks. Even before the rule is done, a few of them, including New York-based Goldman Sachs Group Inc. and Morgan Stanley (MS), ranked fifth and sixth respectively by assets, have shut down some proprietary trading operations and withdrawn investments that are likely to be outlawed under the rule.
“The low-hanging fruit would be those firms that had units operating within them that were clearly proprietary-trading units,” said Julie Williams, the former top lawyer at OCC who now works for Washington consulting firm Promontory Financial Group LLC. “What you’ve seen over the course of the last several years is firms have shut those down or sold them.”
In addition to the ban on proprietary trading, the rule will ban banks from holding more than a 3 percent stake in hedge funds and private-equity funds, which are perceived as too high risk for depository banks. Some banks have already begun dumping investments “where there wouldn’t be a whole lot of debate of whether the fund was a hedge fund or private-equity fund,” Williams said.
For example, this month New York-based Citigroup, the third-largest U.S. lender, announced it will sell its $6 billion emerging-markets private-equity unit. In June, New York-based JPMorgan Chase, the largest U.S. bank by assets, announced plans to break off its private-equity unit One Equity. JPMorgan reported about $7.7 billion in total private-equity holdings in recent filings.
“Where the law is clear, which in key areas it is, they’ve begun to implement that,” Petrou said.
In Washington, lawmakers have pushed regulators to toughen parts of the original draft, particularly an exemption for hedging. The push gained momentum after JPMorgan acknowledged that it lost $6.2 billion from London-based derivatives trades last year. The bank argued that those trades were permitted under an exemption in Volcker for “portfolio hedges” -- trades designed to offset broad risks to the bank’s portfolio. The lawmakers who drafted the provision said they intended such trades to be banned.
“We cannot allow the argument of the banks that they can hedge their entire inventory somehow where we get global hedges,” Senator Carl Levin, a Michigan Democrat, told reporters at a news conference earlier this year. “If they are going to claim that trades are a hedge, they’ve got to be able to identify what is being hedged against, what are the assets being hedged and what is the proof that it is a hedge.”
Curry, 56, said the final rule will clarify “what is appropriately risk-mitigating hedging” and what constitutes proprietary trading. His agency and others fined JPMorgan $920 million earlier this month for bad internal controls and allegedly misleading regulators in the London Whale losses.
Another contested exemption from the Volcker ban is for trades considered “market-making” -- when banks take the other side of transactions for clients who want to buy and sell securities. Industry groups have argued it is difficult in practice for banks to draw a distinction between market-making and trading on their own account.
“It sets up a subjective trade-by-trade analysis spread out over five agencies that is unworkable,” Quaadman said.
Levin and Oregon Democrat Jeff Merkley, who co-authored the Senate provision that became the Volcker rule, have pushed regulators to remove the hedging and market-making exemptions, calling them “ill-advised loopholes.” Merkley has criticized the long delay on a rule that was, according to Dodd-Frank’s original deadline, supposed to be completed in 2011.
“It’s taking so long in part because multiple regulators have to agree, but it’s completely unacceptable,” Merkley said in an interview. “I encourage the regulators to re-immerse themselves and get this work done.”