Volcker Rule Got Tougher on Hedges, Softer on Trader PayYalman Onaran
U.S. regulators made a few identifiable changes to the Volcker rule they approved yesterday after two years of lobbying and negotiation. One is the addition of the word “identifiable.”
The one-word insertion in a section of the 71-page rule tightens restrictions on hedging by banks, the Federal Reserve said in a staff memo, putting the onus on financial firms to prove they’re not placing speculative bets. The rule bars firms from taking positions unless they “demonstrably reduce or otherwise significantly mitigate the specific, identifiable risk(s) being hedged.”
A side-by-side comparison of the original and the final version shows how regulators sought a balance between making the Volcker rule effective and responding to the onslaught by lobbyists who sought to soften the impact on banks. While the compliance duties of chief executives were hardened, other changes relaxed restrictions on how traders are paid and what counts as market-making.
“There are pieces that are weaker and some tougher, but overall it’s better than the previous version,” said Simon Johnson, a finance professor at the Massachusetts Institute of Technology and a member of the Systemic Risk Council, a watchdog group. “A lot will depend on the interpretation by the supervisors and the resulting enforcement.”
Industry executives, lobbyists and lawyers held more than 700 meetings with the agencies responsible for crafting the Volcker rule, part of the 2010 Dodd-Frank Act. A $6.2 billion trading loss by JPMorgan Chase & Co. last year increased pressure to prevent similar blowups in the future.
The Federal Reserve and four other regulators approved the rule almost five years after former Fed Chairman Paul Volcker introduced the idea. The measure seeks to prohibit trading risks that might endanger the banks and the financial system. Restrictions could slice into the $44 billion that the biggest banks make from trading, including $11.4 billion just for New York-based JPMorgan, the biggest U.S. lender by assets.
“I look forward to a process, called for by the new regulation, in which the boards of directors and the top management of our leading commercial banks will cooperate closely in implementing the new rules,” Volcker, 86, said in a statement.
In addition to adding the word “identifiable” to the hedging section, the final version requires a correlation analysis and monitoring of risks over time.
The stricter language prevents “revenue hedging,” or similar practices by banks to guard against “general economic or market developments,” the Fed staff said in its memo.
Bart Chilton, a member of the Commodity Futures Trading Commission, one of the agencies that approved the rule, said in an interview on Bloomberg Television yesterday it was designed to prevent another trading debacle like the London Whale, in which hedges were purported to protect the bank against a weakening U.S. economy. The episode stems from a wrong-way bet made by a JPMorgan trader in the U.K. whose position was so large that it earned him the London Whale nickname.
The rule doesn’t go as far as banning what’s widely referred to as portfolio hedging, where protection is sought for an investment portfolio rather than a specific security.
“Portfolio hedging is still permitted, but there are more restrictions and backstops to prevent vague, loosely defined macro hedges,” said Robert Maxant, a New York-based partner at Deloitte & Touche LLP who advises banks on risk controls.
The final rule dropped an initial definition of market-making as “only designed to generate revenues from fees, commissions and bid/ask spreads.” It also omitted language saying that revenue gained from changes in the prices of assets held would signal inappropriate behavior.
In its place, the current version talks about evaluating a bank’s holdings by looking at historical customer demand. The rule asks institutions to set internal limits on positions held by traders and trading desks based on such history.
“There is a huge public-policy benefit in allowing market-making,” said Douglas Landy, a partner at Milbank Tweed Hadley & McCloy LLP in New York and a former Fed attorney. “If you constrain that too much there is an impact on the markets.”
The original version also took aim at compensation incentives, which had to be tied to “customer revenues and effective customer service.” That connection was dropped, with the final version directing employees not to “expose the banking entity to excessive or imprudent risk.”
The initial proposal would have made it almost impossible for the largest banks to base traders’ pay on a trading desk’s revenue, which is what most institutions do.
The final rule requires bank chief executive officers to attest to the existence of a compliance process, which goes further than the previous version. The 2011 draft said that CEOs need only approve the process. The attestation doesn’t go as far as requirements under the Sarbanes-Oxley Act, which make the CEO attest to the accuracy of a firm’s financial statements and holds them personally liable.
Regulators also relaxed the rule’s global reach, which had drawn complaints from other governments and regulators. The rule would have applied if any party to a transaction was a U.S. resident. The final version exempts non-U.S. institutions’ trading outside of the U.S. regardless of their partners.
It also expanded the exemption for government bonds to those of any country where U.S. firms operate. This means JPMorgan’s French unit can buy and sell French government bonds without any restrictions on proprietary trading. That’s a dangerous loophole that could allow banks to binge on risky sovereign debt, said MIT’s Johnson, who is also a columnist for Bloomberg View.
“Considering that we’ve had three sovereign-debt crises in the last three decades, giving them free rein on sovereign bonds isn’t a good idea,” Johnson said.