Volcker rule ‘to create competitive disadvantages, risk transfer and regulatory arbitrage’

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By:
Lianna Brinded
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Experts say US investment banks will be at a competitive disadvantage if the rule is made legal, regulatory arbitrage will be likely, and the proposed paring down of quotas for hedge fund and private equity clients will lead to a transfer of risk

US investment banks will face a raft of issues if the proposed Volcker rule is passed into law, experts claim.

The 298-page rule, which was issued on Tuesday for public comment, has created a number of consequences – from bank profitability, competitive disadvantages, risk transfer and regulatory arbitrage – which have caused concern across a wide range of market participants.

Profitability

In the official draft of the Volcker rule, named after the former Federal Reserve chairman Paul Volcker and constructed by four regulators, many elements are open to clarification and debate.

One of the main prohibitions within the Volcker rule that has created a mixed reaction within the financial sector is that banks would be banned from trading for their own accounts – known as propriety trading – with only the ability to make short-term trades for hedging or for market making.

Banks would also face a limit on investments in hedge funds and private equity funds.

On Wednesday, analysts told Euromoney how adopting the Volcker rule could cost investment banks or those with investment banking divisions 25% of their profits in years to come. This is a substantial amount of profit for banks to do without in the face of a number of costly overhauls needed to comply with sweeping regulatory changes in the US and Europe.

“If you look at the larger banks, some of them have more than 20% of tier 1 core capital invested in their own hedge funds and private equity funds,” says Scott Cameron, partner at law firm Reed Smith. “So if US institutions are required to be pared back to 3% of core capital, this will mean a material change to their business model and reduce a significant amount of this business.”

However, fund managers say there is a possibility that banks will be able to make up these profits via another route.

“I’m hearing that the banks are taking their proprietary capital and seeding external funds,” says Louis Gargour, CIO at hedge fund LNG Capital. “These funds are typically the traitors they had on the prop desk moving into their own organizations. The rule, I believe, has some sort of three-year statute of limitations, by which time the banks will have recapitalized their investment in the independent company through fee-sharing arrangements.

“In terms of affecting profitability, if the banks seed or have revenue-sharing arrangements with spinoffs, and the spinoffs grow due to the fact they had capital and the backing of an institution, then the banks will directly benefit from the growth of these independent asset management firms, even though they are not really independent and were subsidized in the first place.”

Competitive disadvantage

Despite mixed reactions on bank profitability, market participants have highlighted concern over US investment bank competiveness.

If the Volcker rule were to be implemented, it would mean banks would have to spin off or close down their prop trading desks, leading to, no doubt, a substantial amount of the 10,000 employees predicted to lose their jobs on Wall Street by 2012.

Without these units, experts say that US investment banks will be at an automatic competitive disadvantage compared with European or Asian counterparts.

"There is a lot of concern over how US banks are going to be able to compete with European financial institutions that are less affected by the proposed Volcker rule,” says Cameron, partner at Reed Smith.

“The business model for many US banks will be significantly affected by the proposal, meaning there is a potential for top US banks to be at a serious competitive disadvantage compared with their European counterparts, who follow a different set of rules and may continue to invest higher percentages of core capital in hedge funds and private equity funds.

“The large US banks fixed income business models provide for a significant amount of prop trading that would no longer be permitted if the proposed Volcker rule is adopted in its current form. This would give their European counterparts that are allowed to continue prop trading a definite business advantage.”

Regulatory arbitrage

So, while US investment banks have to deal with the notion that they cannot provide certain services to clients, under compliance of US jurisdiction, experts say this will create regulatory arbitrage.

Cameron, when previously asked about US and European regulatory issues by Euromoney, had detailed how the raft of regulatory changes would push investors East. He revealed how major changes in financial system regulation through history had caused regulatory arbitrage, stemming from the collapse of Enron and WorldCom.

After the enactment of Sarbanes-Oxley in 2002, experts said that this would push Europe, and London in particular, to be the global financial capital. Now with the possible enactment of the Volcker rule next year, lawyers say that another round of regulatory arbitrage could happen again.

“The proposal raises the issue of regulatory arbitrage in the global financial markets,” says Cameron. “In the future, when firms try to do a transaction or line of business which is not permissible under applicable law, they will be more likely to use a different jurisdiction to execute, leaving a geographically segmented market dependent on the activity undertaken.”

Hedge funds, private equity funds and risk transfer

While the US investment banks tussle with the compliance shake-up stemming from the Volcker rule, among other regulatory requirements, during the next year or so, there seems to be a number of opportunities for hedge funds and private equity funds and firms.

“The Volcker rule may provide opportunities in the private equity space, especially in the limited partner community,” says Jeremy Hocter, product manager at private equity technology specialist Pevara. “As the private equity arms of the banks spin off and managers set up on their own, we will see the number of private equity funds increase. This will mean greater choice for limited partners. However, with this greater choice comes the need to select the fund in which to invest more carefully – due diligence around fund investment will grow in importance.”

In the hedge fund space, the growth in the sector will undoubtedly soar when prop trading desks become something of the past for US investment banks.

"The impact of the Volcker ruling on the hedge fund industry will mainly be on the substantial growth in the number of firms and managers out there,” says Hans Hufschmid, CEO at fund administrator GlobeOp Financial Services. “If banks were to dissolve their prop trading desks, the next logical step for these people would be to set up or go to hedge fund firms. We are working with a few spin outs from prop desks. The investment banking clients generally seed their funds and some will replace that capital with outside capital over the course of time.”

Hedge funds have continually seen their subscriptions grow, especially in the light of volatile markets and regulatory changes, such as the Volcker rule, causing concern amongst investors.

GlobeOp’s Capital Movement Index, made from data that represents approximately 8% to 10% of the hedge fund industry – with $170 billion in Assets under Administration –showed hedge fund inflows of 0.31% for October. The figure remains net positive and highlights that as equities have seen a decline recently, alternative investments continue to hold their attraction.

"The Capital Movement Index has provided a number of surprises in terms of subscriptions as well as redemptions,” says Hufschmid. “While redemptions are still low, there is always a lag in terms of gauging hedge fund outflows, as redemptions always require a notice period, which can be anything from one to six months."

“However, subscriptions are still being made, which shows that people are ploughing their money into a place they expect a substantial return from. At the moment, equities are too volatile, fixed income provides low yields, so a diversified portfolio of hedge funds is drawing investors in,” he adds.
 
The GlobeOp Capital Movement Index also represents the monthly net of hedge fund subscriptions and redemptions administered by GlobeOp.

Meanwhile, the hedge fund managers also say that while the Volcker rule will create a competitive disadvantage for US investment banks, there will be more competitivity within the alternative investment space.

Gargour, CIO at hedge fund LNG Capital, says: “It creates a more competitive external fund environment that institutional investors would look at giving money to – if they were to give money to external fund besides themselves.

“It also creates less competition to a bank giving its clients institutional funds, good prices and better execution, as the prop traders are not always leveraging the firm's balance sheet, and are not are utilizing the flow information on what clients want to do to work against them in terms of positioning.”

Other alternative fund managers agree.

“There are now enough hedge funds and private traders around to fulfil the liquidity provision and market efficiency mechanisms that prop desks can be argued to contribute positively to the financial system,” says Lothar Mentel, CIO at Octopus Investments. “Therefore, the risk they introduce to investment banks is no longer justified by these market benefits.”

However, as always, there is a downside to the boom in the hedge fund space, namely the idea of risk transfer.

The Volcker rule’s aim is to create a more stable financial system, by minimising the level of risk investment banks take on in terms of riskier trading, undertaken mainly through prop trading desks.

“Proprietary trading activities, where it has gone beyond what the normal conduct of investment banking business requires, have only ever temporarily helped to improve banks earnings but have always introduced significant earnings volatility – and when not kept in check, brought down [Barings] or impaired banks[Société Générale, UBS] when rogue traders risked and lost billions,” says Mentel.

However, while it is a logical step to assume less risk in the investment banking sector will create less risk in the wider financial system, there is major concern that a boom in the alternative investment industry, which is notoriously more difficult to moderate and regulate, will receive transferred risk from what the Volcker rule tried to minimise in the first place.

“You could make the argument that the Volcker rule will transfer risk from investment banks to the hedge fund industry,” says Hufschmid. “While it may be deemed a right move to create a more stable financial system, there will be fewer people in banks that are able to manage exotic risk and riskier assets.”