Thursday, July 26, 2018

Volte-face on the Volcker Rule

Courtesy: My thought piece in IIFL Wealth Global Newsletter

While industry lobbyists in the US have obviously different takes on the
Federal filing of proposed changes to the Volcker Rule regulations, it’s the
feasibility of rule’s stated objective, of keeping speculation largely out of
the bank’s sight if not mind, that merits a closer look all over again.

Sudhir Raikar

Born out of former Fed Chair Paul Volcker’s firm belief that speculation by
banks played a key role in the financial debacle post 2007, the Volcker Rule
bans proprietary trading by mega commercial banks, given that it inherently
puts tax-payer insured bank deposits at great risk. The rule disallows banks
certain investments on their own accounts, as also constricts their deals with
covered funds, primarily hedge funds and PE funds.
Part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of the
Obama era, (which US President Donald Trump terms a ‘disaster’ with
characteristic disdain) this rule stirred up a hornet’s nest before its July 2015
implementation that was hence preceded by several revisions, exceptions and
even a lawsuit by community banks. Post the rollout, the ensuing ripples kept
the rule in the eye of the storm. Among others, many Wall Street banks were
forced to overhaul their trading operations and forego many big-ticket
investment vehicles. Another notable fallout, many experts claimed, was the
liquidity squeeze in fixed income markets. Revered trading pundits from top-
notch banks quit their jobs to fulfil their hedging aspirations elsewhere. While
many blamed the government for the brain drain, Volcker rule proponents
argued this exodus was in fact a good thing since it ushered in what they
believed was a new era of responsible banking.
Now in the Trump regime, responding to long-held grievances, federal
regulators are revisiting the Volcker Rule to simplify it and tailor compliance in
line with the exact need, i.e. more regulation of firms doing substantial trading
and fewer norms for firms with modest trades.
There’s a faction that believes this proposed amendment is a master plan
hatched in a friendlier political regime. They claim the big banks have teamed
up to denigrate the Volcker Rule under lame excuses like it affects their ability
to serve customer needs or would spell economic doom and invite recession
sooner or later. They claim the big fish among banks are keen to resume their
casino adventures and wish to minimise the number of watchdogs over them by
pushing for Fed to be the sole authority for the Volcker rule enforcement.

And then there are detractors on the other side who demand complete
elimination of the rule, which they say, overlooks the inherent perils of a
commercial bank loan, of placing customary risky bets on the borrower’s
credibility on depositor money that are more harmful than the hazards of
security trading. The Volcker rule, they hold, make banks even more vulnerable
in extending commercial loans and shoddy mortgage loans, in trying to make up
for the missed hedging opportunities. The 2008 crisis, they reason, had more to
do with Lehman and AIG debacles, not with the trade wings of banking biggies.
There’s obviously some merit in the claims on either side, but the crux of the
matter is the subjectivity of the subject matter – how does one distinguish
between a proprietary trade and a market making activity. And is it possible to
distinguish a hedge as either genuine or forbidden? In a typical banking
scenario, a banker can always make a strong case for risk mitigation when he
may actually be speculating on some event happening or not happening like for
instance a rise or fall in a currency bet. Would the new provisions counter that
sticky challenge, or would status quo prevail?

Agreed, making an all-encompassing regulation is never easy. The UK Vickers
draft reforms, that were supposed to be an answer to the Volcker rule, have been
scrapped by the EU, as it was grappling with the enormity of the criteria used to
force banks to split off trading activities, that many believed would create
instability and hinder investments. So, Britain would now go solo on Vickers in
forcing UK banks to ring-fence their retail deposits in a separately capitalised
subsidiary. The ring-fence sounds fine in theory - one bank with two
subsidiaries, retail and investment, almost separate but somewhat together - but
would it work in practice is anybody’s guess.

The ideal situation requires the bank to furnish a detailed explanation of how
specific hedges have been made against specific exposures. Which means the
regulator should be asking for crystal clear hedge-exposure linkages from every
bank. This gives hedging freedom to the bank but holds it accountable in the
same breath.

But reportedly, under the proposed revision, banks would be free to establish
their own risk limits for trades and determine the compliance of such trades
without the need to demonstrate before the regulators. The regulators would in
turn ensure that the banks’ risk limits are in line with customer demand.

Whether banks and regulators would play their parts as they should, or would
the minimal regulation inspire banks to unleash their risk-taking cravings, only
time would tell.