Lew Says Volcker Rule to Prevent Repeat of London Whale Bets

Treasury Secretary Jacob J. Lew said the Volcker rule banning banks’ proprietary trading that regulators plan to vote on next week will prohibit transactions such as JPMorgan (JPM) Chase & Co.’s so-called London Whale and put more responsibility on top Wall Street executives.

“The rule prohibits risky trading bets like the ‘London Whale’ that are masked as risk-mitigating hedges,” Lew said in the prepared text of a speech today in Washington. “And it puts in place strong compliance requirements that require those in charge of financial institutions to make sure that the ‘tone at the top’ sends the right signal to the whole firm.”

Lew is coordinating efforts by regulators to adopt rules intended to prevent a repeat of the 2007-08 financial crisis. The Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp. and Commodity Futures Trading Commission plan to vote Dec. 10, and the Securities and Exchange Commission will act the same day.

The rule named for former Fed Chairman Paul Volcker seeks to stop banks with federally insured deposits from making speculative trades with their own capital that could threaten their stability. It was a centerpiece of the Dodd-Frank law of 2010 during the first term of President Barack Obama.

“Rule-writers will soon put forward a tough Volcker rule that I expect to be true to President Obama’s vision and the statute’s intent,” Lew said.

Hedging Risk

JPMorgan’s London Whale trades, which cost the bank $6.2 billion in 2012, were described by executives as portfolio hedging. The Whale nickname was derived from the size of the positions.

Industry representatives said it is imperative the final regulations don’t impede market making or a firm’s ability to hedge risks.

“An overly restrictive Volcker rule would curtail market liquidity, harm investors and dampen economic growth,” said Kenneth Bentsen, president of the Securities Industry and Financial Markets Association, Wall Street’s biggest lobby group, in an e-mailed statement.

Lew has been committed to ending the notion that some financial companies are “too big to fail,” pressing regulators to finish writing the most important rules three years after Dodd-Frank was approved.

Year-End Deadline

The Treasury secretary didn’t rule out the possibility that he may push for tougher financial rules. In July, he said that “if we get to the end of this year, and we cannot with an honest, straight face say that we have ended too-big-to-fail, we’re going to have to look at other options.”

Today he said that “based on the totality of reforms we are putting in place, I believe we will meet that test, but to be clear, there is no precise point at which you can prove with certainty that we have done enough.”

“If, in the future, we need to take further action, we will not hesitate,” he said in remarks to the Pew Charitable Trusts.

Lew also said he will press other countries to toughen their financial regulations. “We must continue working with other regulators to forge compatible rules so that reforms in other jurisdictions are as strong as our own,” he said. “We must avoid a race to the bottom.”

He said he will “call on the world’s biggest economies to bear down even more forcefully on implementation” when he attends a meeting of the Group of 20 finance ministers in Australia in February.

Repo Market

In a part of his speech on “emerging threats,” Lew said the Fed has “taken important steps” to reduce weaknesses in the market for tri-party repurchase agreements. The tri-party repo market “is a critical source of short-term funding, but one with identified structural vulnerabilities, particularly the reliance on intra-day credit,” he said.

Lew said the U.S. economy “has steadily grown” since the 2008 financial crisis. “Our housing market is recovering. And our financial system is stronger and once again an engine for economic growth.”

The U.S. economy expanded in the third quarter at a faster pace than initially reported, led by the biggest increase in inventories since early 1998, Commerce Department figures showed today in Washington.

Gross domestic product climbed at a 3.6 percent annualized rate, up from an initial estimate of 2.8 percent and the strongest since the first quarter of 2012. The median forecast of 77 economists surveyed by Bloomberg predicted a 3.1 percent gain.

Less Revenue

The Volcker rule will probably curtail some of the $44 billion in revenue Wall Street banks including JPMorgan and Bank of America Corp. (BAC) say comes from market-making.

Market-making, or principal trading, is the business of using a firm’s capital to buy and sell securities with customers, while profiting on the spread and movement in prices.

Goldman Sachs Group Inc. and Morgan Stanley may be the most affected by any additional restrictions since they generate about 30 percent of their revenue from principal trading. JPMorgan generated about 12 percent of its total revenue from principal transactions in the 12 months ended Sept. 30. The figure was less than 10 percent for Bank of America, based in Charlotte, North Carolina, and New York-based Citigroup Inc.

Balancing Act

“Ultimately, the measure of our success will not hinge on how fast regulations were put in place, but whether we strike the right balance,” Lew said today. “That is, maintaining deep, liquid financial markets that promote strong credit creation and lending, and protecting our economy and the American taxpayer from excessive risk-taking.”

Even more important than the final language of the Volcker rule will be its enforcement, said Stephen Myrow, managing director at Washington-based ACG Analytics Inc. and a former Treasury official.

“In terms of classic proprietary trading, most banks covered by Volcker have already exited that business,” Myrow said. “But whether a bank’s sell-side trading operation is conducting proprietary trading or simply managing inventory will often be a difficult and time-consuming call to make in practice.

To contact the reporters on this story: Ian Katz in Washington at ikatz2@bloomberg.net; Kasia Klimasinska in Washington at kklimasinska@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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