Will the Volcker Rule Be Tough Enough?
When Paul Volcker first proposed a ban on proprietary trading by banks in 2009, the financial and regulatory Establishment thought he’d gone, well, crazy.
They said the former Federal Reserve chairman’s idea would harm the economy by delaying the banks’ recovery and limiting their capacity to lend. Besides, the Establishment added, it’s impossible to differentiate trades made for a bank’s own profit from those done on behalf of clients. What was the man even thinking?
Four years later, despite these objections and a formidable campaign of opposition, Volcker’s idea is about to become reality. On Tuesday, five U.S. regulatory agencies are set to adopt a final Volcker rule. Surprisingly, it will honor the spirit of the original proposal -- which is good news -- though just how tough it will be in practice isn’t clear.
Considering the industry’s efforts to water down or delay the rule (regulators received almost 20,000 comments from banks and their allies), it’s a minor miracle that it’s surfacing at all. Volcker’s simple concept has prevailed: “Leave the capital markets to their own devices without any expectation of government protection and keep the existing safety net for the commercial banking system,” he said in 2009.
One example of what that means: U.S. Treasury Secretary Jacob Lew said last week that the rule will require that hedges, which are exempt from the Dodd-Frank Act’s prop-trading ban, must reduce specific and identifiable risks. So they can’t be “London Whale”-type trades like the one that cost JPMorgan Chase & Co. $6.2 billion -- a huge prop-trading position that the bank called a “portfolio hedge.”
In other areas, the regulators have compromised. The rule probably won’t stop banks from designating some proprietary trades as “market-making” -- which the law also exempts so that banks can continue to trade on behalf of clients. Banks will be allowed to keep inventories of stocks, bonds and derivatives for that purpose even if such trades don’t fulfill a specific client order.
That will be all right so long as regulators are alert for signs of abuse, including sharp changes in trading-desk income. True market-making produces a steady flow of revenue from commissions and bid-offer spreads. If income is volatile, it could mean traders are placing bets, and the rule is being applied too mildly.
Also look out for compliance requirements. The rule is likely to require chief executive officers to attest that their banks aren’t doing prop trading. To be effective, such certifications should have to be made in a company’s financial filings, which are audited. Regulators should also be able to demand compliance reports, conduct spot checks and impose hefty penalties on repeat violators. They should be able to penalize individual traders and senior managers -- and to hold managers responsible for making clear to their staff what the new rule requires.
A strong rule should even affect the way employees are paid. To carry out trades that are legitimate hedges or market-making, staff shouldn’t need incentives that reward gambling, which is what prop trading is.
Perhaps the best gauge will be how much trading migrates from the largest firms to independent brokerages, hedge funds and other institutions that have been squeezed out of the business. Large banks receive a variety of subsidies (taxpayer-backed retail deposits, the Fed’s lender-of-last-resort backstop and their too-big-to-fail status) that give them a borrowing advantage when financing trading operations. The Volcker rule, along with higher capital requirements, will minimize those subsidies, which should make trading less profitable for banks and create opportunities for nonbank rivals.
The biggest banks would then be less risky and less likely to need future bailouts, and the financial system would be safer. Not bad for a crazy idea.
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