The Volcker rule: Five things you need to know
In an exclusive interview, a former drafter of the Volcker rule explains why, in its current trajectory, the flagship regulation will fail to distinguish legitimate market-making and proprietary risk-taking while banks sound the alarm on compliance costs, hit to earnings and extraterritoriality concerns.
Of the 400-plus regulations in the Dodd-Frank Act, the US’s sweeping regulatory effort to rein-in Wall Street, the Volcker rule – which would ban banks from proprietary trading – is causing more headaches than any other.
The original rule, proposed by former Federal Reserve chairman Paul Volcker in 2010 when he was the president’s top adviser on economic recovery, would force banks to separate or spin off their trading arms from their deposit-taking/lending operations.
Volcker believed that because of the key role banks’ speculative trading activities played in the financial crisis, there should be a blanket ban on commercial banks trading on their own account.
He argued that, given their importance to the stability of the financial system, allowing banks that are effectively guaranteed by the state to engage in highly risky trading activities posed an unacceptable level of systemic risk.
The approach adopted by the Obama administration is a compromise. It attempts to strike a balance that prohibits risky speculative trading for the bank’s own gain and owning or investing in hedge or equity funds, but permits market-making and hedging functions aimed at ensuring the smooth running of capital markets.
However, more than three years after it was enacted, the Volcker rule has yet to come into force. Indeed the actual provisions are still being thrashed out. The rule should have been complete in 2012, two years after Dodd-Frank, with a July 2014 deadline for banks to comply.
A push is now on to get the rule finalized by the end of the year, but the Federal Reserve is pushing for compliance to be pushed back to at least 2015.
Last year’s $6 billion London Whale trading-losses scandal has reignited a long-running row over exactly where to draw the line between legitimate market-making and hedging, and speculative trading.
With five competing regulatory agencies drafting their own versions – all at odds over how tough the provisions should be – nobody knows what the final version will look like, or when it’ll be ready.
Here the top five things you need to know about the Volcker rule:
Will it work?
Many remain extremely doubtful about the efficacy of Volcker due to the difficulty of determining when market making or hedging becomes speculative – and proving a firm has crossed that line.
Former Treasury department official Don Lamson, who helped draft the original rules, is among the sceptics who argue the Volcker rule is unworkable in its current guise.
“It’s not workable if you expect a reasonably clear definition that permits effective market-making while eliminating impermissible risk-taking because bankers are going to do one of two things,” says Lamson. “They’re either going to go to the edge and take as many risks as they can or they’re all going to act in a herd and cease conduct that looks remotely like trading.
“This is a problem because we won’t get a spread of activity because everyone’s equity is measured on the same basis.”
Lamson is also concerned about Volcker sparking a sell-off and the effect on asset prices.
“The question arises, when the rules go into effect, will there be a shift in the demand curve and the underlying assets will be dumped?” he says.
Uncertainty over when the Volcker rule will take effect is a headache for banks, financial firms and markets, making it difficult to prepare ahead of time and plan the winding down of trading operations.
Complicating matters, the Fed says it is looking at the public interest in giving banks more time to comply. Dodd-Frank allows regulators flexibility to grant banks up to three one-year extensions to conform.
According to Lamson, now a partner at Shearman & Sterling in Washington, from a competitive viewpoint the big issue is who will blink first and start to wind down trading.
“There’s a first-mover disadvantage,” he says. “If you’re a financial institution you want the benefits of engaging in the activities that produce the income that the prohibitive activities throw off. You cease the activities, you cease receiving the profits from those activities.
“So you recognize you have to cease them at one point but you don’t want to do it before your competition does. This first-mover disadvantage is directly traceable to the mistake of the regulators in taking too long in implementing rules.”
Lamson says there are banks that are still making investments in hedge funds at this advanced stage, albeit with side-letters that say they can get out when there are final rules.
The complexities of the Volcker rule mean it will have a substantial impact on banks through the day-to-day and longer-term operational costs of compliance.
The picture here is mixed, with many banks including two of the biggest Wall Street investment banks having shuttered or sold their big trading desk operations and liquidated investments likely to be banned under the final rules.
However, while Volcker mainly targets the US’s mega banks, it could affect most of the country’s 7,000 deposit-taking banks, and activity that is less clearly proprietary continues.
Banks are aggressively expanding their compliance divisions. The American Bankers Association has estimated the rules will require 6.6 million hours of work to implement and an additional 1.8 million hours per year to maintain compliance.
Initial estimates put the number of additional staff that US banks would need to hire at 3,000 and total compliance costs at $1 billion. However, with the rules running to more than 1,000 pages, the time cost and time involved in analysing every trade to ensure compliance will be exponential.
In addition to re-assigning staff in their thousands to risk and control, banks have also, in the past two months, embarked on a hiring spree.
“At this point the question arises, what is a reasonable price or cost for this benefit,” says Lamson. “The costs are massive and they are going to have to be passed on to customers.”
The CEO of one the largest Wall Street banks is famously quoted as saying: “We are going to have to have a lawyer, compliance officer, doctor to see what their testosterone levels are, and a shrink, what is your intent.
Mike Trippitt, banking analyst at Numis Securities, says: “At the margin it’s very difficult to distinguish and there’s a grey band where market making can look a little bit like prop trading at times, especially if profits are being made.”
Trippitt believes the manpower required will be substantial, in part because foreign banks with US subsidiaries or trading desks are also affected. He says the increased overall regulatory burden has seen one big UK player planning to add more than 2,000 compliance personnel globally.
Impact on profits
Banks will see a reduction in profits from the lost income that would have been contributed by proprietary trading activities. Standard & Poor’s estimates Volcker could pull down the profits on the eight largest US banks by between $2 billion and $8 billion a year, according to how tough the final rules turn out.
“One of the biggest issues is the fund business,” says David Felsenthal, partner at Clifford Chance in New York. “If banks can’t invest in funds, how are they going to arrange their relationship with funds and what does that mean for the asset-management side of the banks’ business?
“Then there’s the problem of derivatives with funds and there’s a whole set of issues surrounding rules that restrict derivatives and other transactions with funds, and how that’s going to pan out.”
Numis’s Trippitt says profitability is already under pressure massively for investment banks.
“When you’ve been asked to hold about three times the level of capital and you’ve doubled your cost base because of bonus caps, ROEs are under pressure. The question is: where does it settle?”
Trippitt says the only way ultimately to remain profitable is about business mix with well-developed equities/M&A advisory business, which is clearly not a capital requirement. “While the days of being profitable through being a fixed-income flow-monster are not over, the ability to do that is going to be quite limited.”
Volcker is aimed principally at US banks and applies wherever they operate, but it is also likely to affect foreign banks operating within the US through subsidiaries or separately capitalized units, thereby extending its reach much further afield – possibly worldwide.
Some of the most vocal critics of Volcker have been foreign banks, regulators and governments – including Canada, the UK and Japan – concerned at what they say is its unprecedented extraterritorial reach. UK MPs have warned that the law could disincentivize transactions with US counterparties.
“Any bank that has a branch or bank subsidiary in the US is potentially subject to the Volcker rule,” says Clifford’s Felsenthal. “What is that going to mean for their non-US activities? We don’t really know but the rules in the proposal are pretty wide-reaching. It’s pretty aggressive.”
How the rules are interpreted is likely in some instances to result in inconsistencies in how the rules are applied.
One rule that grates is an exemption on proprietary trading in US government securities, but not the treasuries of other sovereigns unless it takes place solely outside the US.
Uncertainty as to what the ‘solely outside the US’ exception means and how it would work in practice could make it unworkable for many institutions headquartered in other countries.
So, for example, Canada-based banks that have their trading desks in New York will, on the face of it, be prohibited from trading their home country’s securities.