Ex-Citigroup CEO Says Volcker Rule Needs ‘Severe Penalties’

John S. Reed, who helped engineer the merger that created Citigroup Inc., said the U.S. should make the proposed Volcker rule stronger by targeting bank traders’ pay and using “severe penalties” to enforce it.

Regulators should ensure traders are paid “based on the results of their market-making and hedging activities after those positions are fully unwound,” Reed wrote in a letter to regulators yesterday. There should be “specific and vigorous penalties for individual traders, management and firms” who don’t comply with the new regulations, Reed wrote.

The letter from Reed, 73, was among comments filed yesterday with regulators who are finalizing the Volcker rule, which bans banks that accept deposits from trading that could put their firms at risk and create another financial crisis. Lenders including New York-based Citigroup, Goldman Sachs Group Inc. and JPMorgan Chase & Co. have called for revisions amid concern that the rule could harm profits.

“A strong Volcker rule is one of the most important provisions to prevent “too big to fail” financial institutions, stop conflicts of interest and support credit in our economy,” Reed wrote. “Failure to comply should be severely punished.”

CEO Sign-Off

Reed said the proposed Volcker rule should be strengthened by requiring chief executive officers to sign a statement each quarter affirming that they are complying. Reed, 73, who held CEO titles at Citigroup and its predecessor from 1984 to 2000, sent the letter from the bank’s premises at 425 Park Avenue in New York, where he keeps an office. The company is now the third-largest lender in the U.S. by assets.

Regulators must change how traders are paid to prevent abuse of the activities that the Volcker rule still permits, Reed wrote. This includes market-making, when a trader acts as a matchmaker for buyers and sellers, and hedging, when a trader seeks to minimize losses from another trade.

Banks should adjust pay by risk or tie performance to a benchmark, such as an index of the assets involved, he said. Properly crafted, the rule would allow traders to get paid appropriately while encouraging them to get out of positions as soon as possible and discouraging them from carrying inventory, according to Reed.

Pressure on Pay

“Without strong rules that align interests, we will see another race to the bottom,” Reed wrote. “Traders, management directors and even shareholders will seek to game even the best-written rules governing permitted trading in the hope that they can attain the supersized rewards made possible by high-risk investments.”

The curbs could put more downward pressure on compensation for Wall Street, where firms already are slashing pay packages and changing compensation formulas as they grapple with lower revenue. Some are giving less cash and more stock, or deferring a greater percentage of total pay. Citigroup cut bonuses for investment bankers by an average of 30 percent, a person briefed on the matter has said.

Molly Millerwise Meiners, a spokeswoman for the bank, declined to comment on Reed’s letter. Citigroup filed its own comment letter saying the proposal “should be recalibrated to make it simpler, less burdensome to implement, and most importantly, consistent with preserving the functioning of global trading markets.”

Reed’s letter was addressed to the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp., the Securities and Exchange Commission and the Commodity Futures Trading Commission.

Building Citigroup

The rule, named after former Fed Chairman Paul Volcker, was included in the 2010 Dodd-Frank Act in an effort to restrict risky trading at banks that operate with U.S. guarantees. Regulators released the 298-page proposal seeking comment on how it would affect market-making, liquidity, foreign institutions and private equity and hedge funds.

Citigroup formed in 1998 when Reed’s Citicorp, a commercial bank, combined with Sanford I. Weill’s Travelers Group Inc., which owned the investment firm Salomon Smith Barney Holdings Inc. The merger went ahead after repeal of the Depression-era Glass-Steagall Act, which had separated traditional banks from those involved in capital markets.

Rebuilding the Wall

Reed has since said this was wrong and apologized for his role in building Citigroup, which lost $29.3 billion in 2008 and 2009 combined, much of it tied to subprime mortgage bonds. Reed, whose tenure as CEO overlapped with Volcker’s at the Fed, wrote to the regulators yesterday he supports the propsed rule’s “efforts to establish a modernized Glass-Steagall wall between traditional client-oriented banking and the high-risk trading activities that helped cause the collapse of the world’s financial system.”

The Volcker rule is set to take effect in July even if the rule-making is still in progress, and would include a two-year transition period. The Federal Reserve would then have the ability to issue multiple one-year implementation extensions on a case-by-case basis.

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