For details of the proposal, please see our eAlert Obama proposal for new restrictions on size and scope of U.S. financial institutions .
The Volcker Rule would apply to all U.S. bank holding companies, and to the U.S. subsidiaries and branch offices of non-U.S. banks. However, 10 days later much remains unexplained about the Volcker Rule, including many details about how it will be imposed (the Secretary of the Treasury has been charged at drafting new legislative language). There are several practical questions which we expect need addressing.
Are we throwing out the baby with the bath water?
The Volcker Rule would separate commercial banking, on the one hand, and certain principal activities considered too risky or inherent with conflict, on the other. What is unclear is why an absolute bar is now thought to be needed when the administration's own plan previously had left such determinations to the financial regulators.
Specifically, on 11 December 2009, the House of Representatives passed H.R. 4173 (the Wall Street Reform and Consumer Protection Act of 2009); and the Senate is reviewing similar provisions in committee.
In Section 1104 of H.R. 4173, the Board of Governors of the Federal Reserve System (the Federal Reserve) in conjunction with the Financial Services Oversight Council (which would be made up of representatives from all of the federal financial regulators) would be granted the authority to take exactly the actions proposed by the Volcker Rule:
the Federal Reserve could
limit the size of systemically-risky entities
reduce or eliminate their ability to engage in lines of business found to be unsafe and unsound
take a variety of other actions directed at reducing or eliminating systemic risk.
The Volcker Rule takes away regulatory discretion over a few areas of "systemically risky activities" while leaving regulatory discretion over other areas of systemic risk. If the regulators failed to properly exercise their authority in the past, why would the proposal leave such discretion in their hands in the future? Further, what is the reason for applying this proposal to all banks when just a few may have conflicts or raise systemic risk (as Chairman Volcker himself testified to at the Senate)?
Can we really roll back the convergence of financial institutions and products over the last few decades?
25 years ago there was a clear difference between commercial banks and investment banks. Commercial banks took deposits and lent money. Investment banks underwrote securities offerings, made markets and offered brokerage services. These distinctions have largely eroded as barriers between similar types of financial products have reduced. The Volcker Rule itself acknowledges this by permitting for commercial banking groups activities such as securities underwriting that were barred for decades under the Glass-Steagall Act (GSA).
The Volcker Rule essentially identifies the riskiest of financial activities and moves them away from the highly regulated and supervised jurisdiction of bank holding companies (BHCs – entities that own or control banks) into less supervised areas.
Chairman Volcker noted in his written testimony on February 2, 2010 to the Senate Committee on Banking, Housing, and Urban Affairs that "a number of the most prominent [investment banking] firms, each heavily engaged in trading and other proprietary activity, failed …"
Arguably, the Volcker Rule would make future failures of such entities more likely as it does not fix the liquidity funding problem that ultimately led to many of these failures: investment banks were funding long-term assets with short-term repurchase agreements and commercial paper; and a separation of investment banking from commercial banking (which has access to FDIC insured deposits for liquidity, as well as the Federal Reserve discount window and the Federal Home Loan Bank system) acerbates this problem.
The Volcker Rule proposes size and concentration limits on commercial banks, but it fails to place such absolute limits on the riskier investment banks. Arguably the investment banks were in the midst of transforming their businesses into more stable, more diversified financial institutions in order to compete with the larger, better capitalized commercial banks. The Volcker Rule would cut that convergent transformation off.
What about broker-dealers whose accounts are insured by the Securities Investors Protection Corporation (SIPC)?
In recent opinion pieces published in the press, and in his written testimony to the Senate, Chairman Volcker stated that it was inappropriate for commercial banks to engage in the identified risk activities because of their access to the "long-established 'safety net' undergirding the stability of commercial banks – deposit insurance and lender of last resort facilities." However, commercial banks are far from the only financial institutions subject to implicit (or explicit) governmental support.
Registered broker-dealers that are members of the SIPC have the privilege of offering brokerage deposit insurance to their brokerage accounts. While SIPC coverage is not an exact replica of the deposit insurance offered by the Federal Deposit Insurance Corporation (FDIC), it certainly is a federal "safety net" not available to other financial and non-financial entities. Many registered broker-dealers also engage in proprietary trading and principal investing. Wouldn't the logical application of the Volcker Rule require analysis of all financial entities supported by any of the myriad of U.S. governmental support programs?
The Volcker Rule seems to take one step in this direction by canceling the ability of investment banks (which often are registered broker-dealers) to access the Federal Reserve's liquidity facilities; but why wouldn't it also remove the rest of the federal "safety net" available to such financial firms? (And if it doesn't, why are commercial banks singled out for this treatment?)
Traditional bank principal activities?
Banks have made markets in certain traditional banking products, such as currency and bullion, for time immemorial. Banks are also among the most active traders of government and municipal securities. Even under the GSA banks were permitted to make such trades. These markets are among the most liquid in the world. Will banks be permitted to continue this business?
Bank holding company activities permitted by the Bank Holding Company Act?
The Volcker Rule seeks to eliminate the ability of commercial banks to affiliate with an entity that owns or sponsors hedge funds and private equity funds. Under Section 4 of the Bank Holding Company Act of 1956 (BHCA), and before its amendment by the Gramm-Leach-Bliley Act of 1999 (GLBA), BHCs have been permitted to own entities engaged in activities closely related to banking, and to make non-controlling investments (generally of up to five percent voting securities and 25 percent total equity). Under GLBA, Section 4 of the BHCA was amended to permit certain well-capitalized and well-managed BHCs to make passive, but controlling merchant banking investments in any type of entity.
Is the Volcker Rule to eliminate these BHCA powers? Currently, BHCs can engage in a broader range of proprietary activities outside the U.S. than inside the U.S. (such as Edge Corporations), will this distinction continue?
Are we just repeating the past?
After the Wall Street crash of 1929, the Senate tasked the Pecora Commission to investigate its causes. The findings of the commission included many significant conflicts of interests between banks and their customers. From these findings came the GSA, the Securities Acts of 1933 and 1934, and many other provisions of our modern financial regulatory structure. Over time the Pecora Commission came in popular culture to stand for the concept that these conflicts of interest caused the stock market crash and the following Great Depression.
This is unsupported by the economic evidence and has now been largely discredited by economic historians, which is why the GLBA largely removed those barriers. GLBA did not permit banks to go back to the ways of conflicts of interests; instead it relied on regulatory standards and supervision/examination of bank entities to police against such abuses.
The Volcker Rule proposes to reinstate several GSA barriers aimed at removing conflicts of interest but no evidence has been introduced that such conflicts lead directly or indirectly to the financial crisis. Why not wait until the Financial Crisis Inquiry Commission issues its findings at the end of 2010 to allow a fact/evidence based approach to regulatory reform?
Can we really determine what is customer-driven versus principal activities?
Chairman Volcker testified that "every banker I speak with knows very well what 'proprietary trading' means and implies." He also pointed to an analysis of volume relative to customer relationships and of relative volatility of gains and losses, such as patterns of exceptionally large gains and losses.
It is certainly true that regulators have long been making these determinations for banks and BHCs. The Office of the Comptroller of the Currency (OCC) lists examples of customer-driven activities in its list of "Activities Permissible for National Banks," and the Federal Reserve lists certain types of customer activities and eligible proprietary trading for BHCs in its Regulation Y. Each regulator permits (and requires) proprietary hedging activities. These distinctions, however, were made in the context of a commercial banking business rather than in a traditional proprietary trading business.
The devil here will be in the detail of the drafting being left to Secretary Geithner (and then in application to the regulators), but we expect most investment banks would have little trouble finding connection between their high volume, low return customer business to their lower volume, higher return proprietary business, making the Volcker Rule incredibly difficult to police.
Some unintended consequences?
Market-making: the U.S. capital markets are the deepest and most liquid in the world. The Volcker Rule will likely lead to fewer entities engaging as market makers. What will the effect of this reduction be to the securities markets?
Primary dealers: The Federal Reserve Bank of New York (New York Fed) trades U.S. government and select securities with designated primary dealers, including large commercial banks and investment banks. These banks assist the New York Fed in implementing monetary policy. Presently there are 18 primary dealers; over 95 percent of these entities would be affected by the Volcker Rule which would restrict such entities from entering into proprietary trades with the New York Fed. The New York Fed would be left with smaller capitalized and less internationally active counterparties. How will this affect the New York Fed's ability to implement monetary policy?
Competitive issues: Chairman Volcker believes that a "strong international consensus on the [Volcker Rule] would be appropriate, particularly across those few nations hosting large multi-national banks …" In his testimony he also pointed out supporting statements on the proposed rule that have been made by regulators in the UK and by President Sarkozy of France. The lesson of the last months to us has been the divergent and different speeds of approach by governments and regulators in the U.S., UK, EU and G20 generally. International consensus has not been transformed into coordinated action. So we expect the Volcker Rule is unlikely to be uniformly implemented in every country that has banks active in the U.S. This competitive disparity will require the U.S. regulators to apply equal restrictions to such non-U.S. banks. These actions will most likely drive financial services business off-shore and diminish the U.S. as a financial capital.
Counterparty exposure: There are many methods by which commercial banks will be exposed to those activities to be barred by the Volcker Rule. If proprietary investment banking is cleaved away from BHCs, it will need to be funded somewhere. We suspect that it will be the large commercial banks that lend money in prime brokerage structures to hedge funds, private equity firms and proprietary trading entities. If these entities fail (and they will assuredly be less capitalized and more prone to fail than BHCs are), these same commercial banks will bear the losses.