Regulators are on the horns of a dilemma as they attempt to balance the conflicting concerns raised by their proposed rule for the implementation of the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act banning FDIC-insured financial institutions from proprietary trading. Those concerns will be the topic of a discussion moderated by Martin Fridson, Global Credit Strategist for BNP Paribas Asset Management, at NYSSA’s upcoming 22nd Annual High Yield Bond Conference.
The Securities and Exchange Commission, the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency released their joint implementation proposal in October 2011, and their request for comment resulted in over 14,000 letters. The Agencies’ proposal states the upfront challenge: that the delineation of what constitutes a prohibited or permitted activity under the Volcker Rule “often involves subtle distinctions that are difficult both to describe comprehensively within regulation and to evaluate in practice.” It goes on to say that the Agencies’ proposed rule was crafted to “not unduly constrain banking entities” in their business to provide “client-oriented financial services including underwriting, market making, and traditional asset management services,” but, at the same time, not to conflict with “clear, robust, and effective implementation of the statute’s prohibitions and restrictions.”
Not surprisingly, the Agencies’ best efforts to navigate these contentious waters appear to have satisfied few. On the one hand, industry lobbyists claim the Agencies’ rule places complex and onerous requirements on banks to prove that they are not engaged in propriety trading. They contend that the proposed rule will seriously compromise their market making function, raise the cost of capital, and result in knock-on effects for the economy, employment, and the banking industry’s global competitiveness.
Public interest advocacy groups, on the other hand, are clamoring just as energetically for a “bright line” interpretation of the Volcker rule that ensures banks have no room to circumvent its original intent. The latter claim it is the banking industry’s own success at lobbying to create exceptions to the Volcker Rule prohibitions on proprietary trading that led to the complexity of the Agencies’ current ruling. Many on both sides of the fence now argue that the proposed regulations will be unenforceable and should be simplified or scrapped and entirely rewritten.
A study by Oliver Wyman commissioned by the Securities Industry and Financial Markets Association illustrates the industry’s broad case against what it calls a “restrictive interpretation of the Volcker Rule. It warns of the huge liquidity impacts that would arise, including higher corporate funding costs, a reduction in household wealth due to compromised functioning of securities markets, reduced access to credit for small businesses, reduced ability for investors to exit investments, higher trading costs and lower returns for pension and mutual funds, and reduced ability for companies to transfer risks resulting in a “reduction in overall efficiency of the broad economy.”
Perhaps one of the most closely reasoned responses to industry’s criticisms of the Volcker Rule has been advanced by Wallace Turbeville, a former Goldman Sachs investment banker who testified in January 2012 before the House Committee on Financial Services on behalf of Americans for Financial Reform. In his testimony he pointed out that industry analyses of liquidity impacts have downplayed or largely ignored the reality that the Volcker Rule could not be interpreted in any way as a prohibition against proprietary trading. These activities, Turbeville, says, will instead migrate to non-taxpayer protected institutions. The Volcker Rule, he notes, merely “prohibits institutions that enjoy the benefits of a federal safety net from engaging in the risky businesses of proprietary trading and hedge fund sponsorship and ownership.” In his opinion, it will be a good thing if the rule does result in “the unavailability of cheap capital (subsidized by the public) that induces financially unsound trades.”
Turbeville also describes another positive outcome of the Volcker Rule if properly enforced—a reduction in covered banks’ capital bases. “The massive growth of [covered bank’s] assets and the capital to hold them dates from about 1980 when they started a race to compete with each other in the increasingly de-regulated trading markets,” he reports. “Every day until the Volcker Rule is implemented, the American people bear the risk associated with de facto guaranteeing these bloated capital bases.”
Turbeville acknowledges that the rule will have impacts on block trading but he maintains that is also all to the good. “Large market participants, such as mutual funds, can direct massive flows of trading activity to banks and commonly take advantage of this market power,” he notes. “In the post-Volcker Rule environment a given block trade may have to be transacted in smaller units. This is because the non-bank institution will be more sensitive to risk, and because the capital charge will reflect reality, not public subsidy.”
Turbevile reports that as the current July deadline for conformance to the rule approaches, the conversation around what it means to make a market has gotten more detailed and more focused. “There has been an informal sharing of thoughts that has been highly constructive,” he notes. What has emerged, says Turbeville, is a line in the sand. On the one side of that line are those who contend that covered banks must not under any circumstances enter into a transaction unless it has information from a market source about what the outcome of that transaction will be. On the other side are those who would say there should be exceptions to that rule. Whether the Agencies’ final ruling will reflect one or the other interpretation, or will remain in something like its present problematic state remains to be seen.
“We are analyzing the comments and determining a prudent way forward in close consultation with the banking agencies and the CFTC,” says David Blass, Chief Counsel and Associate Director for the SEC’s Division of Trading and Markets. “It is a challenge given the quality and quantify of comments—there are 14,000–15,000 responses in form letters alone.”
The bulk of comments have come from industry groups—not just from covered banks but from an array of institutions on both the buy side and sell side, including mutual and pension funds, hedge funds, and sovereign debt and municipal securities issuers. “I can say we are taking to heart the volume and the diversity of the messages from the comments that have come in,” says Blass. “But we know at the end of the day it is our responsibility to look to what the Volcker Rule was intended to do and not just to listen to interest groups.”
“We have to work through the comments and this goes with every rule, the Volcker Rule is not unique,” Blass reports. “But an added complexity here is that other agencies are involved in the process and we need to coordinate with them. I cannot predict at this time what will happen between now and July 21, though commenters have called for the Fed to extend the conformance period for the statutory provision past July 21, the date the statutory provision otherwise takes effect.”
–Susan Arterian Chang
Susan Arterian Chang is a contributing writer to The Finance Professionals’ Post and Director of Capital Institute’s Field Guide to Investing in a Resilient Economy