Is the Volcker Rule Already Working?

As any police officer walking the beat knows, sometimes all you need is a warning shot to deter misconduct. Washington may be seeing something similar these days with Wall Street banks and the Volcker Rule.

That would be the rule to prohibit commercial banks from investing depositors' money into propriety trading—and which also hasn't actually been written yet. Draft language circulated by the Securities and Exchange Commission, however, has already left many financial firms aghast at its complexity. Recent actions by some of the nation's largest banks suggest that the mere specter of compliance with the Volcker Rule (whatever its final form) is prodding them to curb risky trading and dodge that slow-moving regulatory train wreck before it arrives.

The banks “know there is money to be made, and they do not want to be behind the curve in being in position to do business with new regulations,” says Elven Riley, director of Center for Securities Trading and Analysis at. “They are ahead of the curve for implementation because it takes time to move these businesses around. You don't toss a hedge fund out of a major too-big-to-fail bank without some effort. It's a lot of work to do that, so they have moved ahead of the regulatory impact.”

The first moves started happening last year. As early as July 2012, the U.S. Comptroller of the Currency was reporting that large banks—Bank of America, Citibank, Morgan Stanley, Wells Fargo, and others—had begun efforts to shutter their proprietary trading operations. Goldman Sachs sold off millions of dollars of its hedge fund investments, a move intended to help meet an expected Volcker Rule demand that banks be limited to investing no more than 3 percent of their capital in such funds.

“In financial services, people are trying their best to look around the corner,” says Nicole Sandford, national practice leader for governance and enterprise compliance at Deloitte & Touche. “They are asking, ‘What's the next thing regulators are going to be telling me and how do I get ahead of that?' ”

Also in a move to better delineate trading done on behalf of customers, employees at Citibank are no longer allowed to invest alongside them in the funds they offer, what had been a longstanding practice. While stopping short of a comprehensive ban, banking giants UBS, JPMorgan Chase, and Morgan Stanley have also imposed new restrictions on what funds employees and advisers can participate in.

“The industry, as a whole, has recognized that this was not going to go away, and had to show they were responsible participants and move ahead,” says Riley, who previously had a 30-year career on Wall Street that included positions at Salomon Brothers, Citigroup, Deutsche Bank, Lehman Brothers, and UBS.

That early, focused response bodes well for the future, he adds. With the Dodd-Frank Act, there was a “sea-change from the previous mindset in government and the financial industry, that self-regulation was going to win the day.” The law also helped shift a regulatory approach that had become very product-centric, not market-centric.

“People didn't think they could, or should, regulate a market,” Riley says. “There is the practical reality of how do you say, ‘Don't do bad things?'”

Oliver Ireland, a partner with the law firm Morrison Foerster who practices in retail financial services and bank regulatory issues, agrees that many in the financial world have taken the initiative. “If they see a statutory change, they start to move toward dealing with that before rules are final,” he says.

“People didn't think they could, or should, regulate a market. There is the practical reality of how do you say, ‘Don't do bad things?'”

—Jennifer Taub,

Professor,

Vermont Law School

He worries, however, about the uncertainty that still surrounds how the Volcker Rule will ultimately be structured. “The Volcker Rule is very detailed, but what it ultimately means depends a lot on how [the SEC and other regulators] interpret various exceptions in the rule,” he says.

Waiting for those interpretations is the hard part, he adds, because each one could have implications for banks' policies, compliance programs, data collection, reporting, and so forth—and, Ireland notes, “banks are not nimble.”

Some of those uncertainties and interpretations: what constitutes “market making,” sometimes a necessary part of keeping a security liquid; and the exact definition of what falls into that forbidden category of proprietary trading.

Ireland also views the Volcker Rule as, in some ways, a solution in search of a problem. He isn't convinced proprietary trading had as much to do with the financial crisis as some claim, as much as a collapsed bubble in housing prices and shoddy underwriting of mortgage-backed securities.  

“Is [the Volcker Rule] altering behavior? Yes, it probably is,” he says. “Is it reducing systemic risk? I don't think so. I could argue that it actually creates problems. In the long run, it may reduce market liquidity, and that could contribute to problems in the future.”

WHAT NOW FOR BANKS?

The following is a selection from a March 2013 report prepared by PwC, ““Are Banks Keeping the [Good] Faith?” It looks at compliance issues banks face in meeting the “good faith” demands presented by regulators in advance of a final Volcker Rule.

Conduct a business impact analysis

Banks need to know which of their businesses, products, and regions are at risk under Volcker. They need to determine how the rule will impact their revenues and cost across all of their businesses globally and prepare a strategic response. Leading banks have already:

Identified their most impacted trading units, such as desks that trade in illiquid markets and therefore buy and hold in anticipation of an event; some banks have estimated a risk of decline in trading revenues of up to 20 percent.

Performed risk assessments across the units globally, and have determined that common practices, such as pre-positioning in anticipation of client flow will likely prove problematic.

Conducted analyses regarding investments in or transactions with covered funds, and have considered actions to mitigate potential issues (divert, or maintain within allowable thresholds).

Prepare to Prove Your Good Faith

Banks must be able to demonstrate their good faith during the conformance period and regulators have already begun to assess their actions or lack thereof. At a minimum, banks will need to produce the following information:

An overview of the Volcker program approach, including governance structure and status reporting on its assessment efforts to date.

A description of how management has defined key Volcker terms, such as prohibited and permitted trading, in order to develop their institution-specific view of Volcker.

An analysis of the expected impact of the rule on the bank's business, including the impact on revenues, customer relationships, impact on the bank's risk profile, and the ability to manage the risk and the additional cost of compliance.

An inventory of existing funds and investments and an analysis of the impact on those funds and investments under the rule's covered funds provisions.

Source: PwC.

Don't forget, too much systemic risk in the financial system is what brought the economy to the brink of collapse in 2008, and reducing that systemic risk is what the Dodd-Frank Act of 2010 was supposed to achieve. So three years later, how's that going?

“The goals of reducing systemic risk have not been realized,” is the blunt assessment of Jenifer Taub, a professor at Vermont Law School who specializes in financial reform.

“The conditions that brought the financial system to the brink of collapse five years ago persist,” she says. Those conditions, in her view, are the size of bank holding companies, the leverage they're permitted to use, and “dependence upon very short-term, often overnight funding, to finance much longer term assets.”

As size goes, the top six bank holding companies are larger than ever, both in an absolute sense and also relative to GDP, Taub says. At the end of 2006, total assets for the top six were about 55 percent of GDP; as of April 1, 2013, they were 60 percent.

Trillions of dollars are still borrowed through the short-term and overnight repurchase agreement markets. (Fans of the Great Recession will also recall that funny business in repurchase agreements drove Lehman Bros. into bankruptcy in September 2008 and sparked the crisis.) “Especially when they are used to finance illiquid or much longer-term assets, these types of transactions create vulnerabilities and dangerous interconnections between firms and were the location of the run on both Bear Stearns and Lehman Brothers,” she says.

Even though banks have scaled back many of the investments that might run afoul of the Volker Rule, Bart Chilton, a commissioner with the Commodity Futures and Exchange Commission, fears that some of those prohibitions aren't more directly spelled out by the legislation. While the rule seeks to stop banks from conducting speculative trading, banks can still hedge legitimate business risk. When banks own physical commodities, they may contend that they should be able to hedge against associated risks, an approach that could amount to “yet another work-around the Volcker Rule.”

Chilton, in a letter to Federal Reserve Chairman Ben Bernanke, urged that the final Volcker Rule “be written in a precise and surefooted fashion that allows only for appropriate hedging of banks proprietary risks, but firmly prohibits speculation.”

“Why can't the banks just get back to banking?” Chilton asked.

Riley says that no matter what positive steps banks have already taken, it is important that the Volcker Rule (and other key pieces of the Dodd-Frank Act) are not delayed or detoured. “Things can roll back just as easily as they rolled forward,” he says. “The actualization of the regulations still needs to occur.