Months after the July 1 deadline to finalize the Volcker Rule—a cornerstone of the Dodd-Frank Act that places limits on proprietary trading by banks and on other activity that regulators consider risky—the provision remains in limbo, leaving open the door for those pitching alternatives and others demanding its demise.
Section 619 of the Dodd-Frank Act, referred to as the Volcker Rule, is intended to lower the level of risk banks can take by prohibiting proprietary trading except for the permissible activities of hedging, market making, and underwriting, and by limiting the ability of banks to own hedge funds and private-equity funds. The idea is that banks with customer deposits insured by the Federal Deposit Insurance Corp. and with access to the Federal Reserve's discount window shouldn't be taking risks that endanger the financial system.
The rulemaking has been delayed for more than two years by debates over how to effectively define those exceptions, and an overall reticence by banks to take on new regulations that could impact their liquidity.
Late last month, Senators Jeff Merkley (D-OR) and Carl Levin (D-MI), lead authors of a provision that led to the Volcker Rule's inclusion into the Dodd-Frank Act, demanded an end to the delay in a letter to Federal Reserve Chairman Ben Bernanke and regulators.
“While we are cautiously pleased to see reports that a consensus is emerging, we are concerned that some ongoing staff-level differences may be obstructing progress,” they wrote. “The time for resolving those differences is long overdue. The final regulations needed to implement the ban on high-risk trading and conflicts of interest should be issued without delay and no later than the end of the year.”
In response, top regulators—including Securities and Exchange Commission Chairman Mary Schapiro and Martin Gruenberg, acting chairman of the Federal Deposit Insurance Corp.—have stated that even though their agencies still have their differences, a final draft is still on track to be released by the end of the year.
That means the clock may be ticking for alternatives promoted by the rule's critics, including those who want rulemaking similar to recent initiatives by regulators in Britain and the European Union, and others who favor empowering bank supervisors to pursue risky bank behaviors on more of a case-by-case basis. Others would prefer ditching the whole thing for a return to the Glass-Steagall Banking Act of 1933.
In anticipation of the multi-agency rulemaking, individuals and organizations on all sides of the issue have submitted more than 19,000 comment letters to various agencies. Recently, several mid-sized banks—including U.S. Bancorp, SunTrust Banks, and PNC Financial— announced that they had engaged lobbyists in an effort to push for more favorable treatment under the rule.
Volcker Alternatives
The delay offered an opportunity for outgoing House Financial Services Committee Chairman Spencer Bachus (R-AL) to invite the public to suggest Volcker Rule alternatives. Although that effort, which ended in September, has yet to lead to a formal hearing or counter-proposal, it did attract comments from high-profile organizations.
The Securities Industry and Financial Markets Association and Financial Services Roundtable presented an alternative” that relies on already proposed capital rules and regulations (including those in Basel III international standards) rather than activities restrictions. Their ideal rule would reverse the presumption that all short-term principal trading with intent to profit from price movements, wherever located within a bank, is impermissible. The proposal also advocates preserving a bank's ability “to engage in socially and economically useful” activities, such as market making, and eliminate the requirement that activity be designed to reduce “specific risks” to a bank and instead allow more generalized mitigation.
“I think it is quite clear, even after Dodd-Frank, that banks are still too big to fail. In fact, they are much bigger than the last time they failed.”
—Ted Kaufman,
Chair,
Congressional Oversight Panel
The American Bankers Association also weighed in with a call for “full repeal.” Barring that, it wants to sharpen the rule's focus on what constitutes prohibited activities to provide certainty that banks can still engage in market-making, asset liability management, and hedging.
All three groups said the Board of Governors of the Federal Reserve System should have exclusive authority to interpret the Volcker Rule, rather than all five regulators jointly, and it should have authority to provide exemptions.
Hal Scott, a Harvard Law School professor, has been following the various proposals closely. He suggests that regulators take a step back and examine the banking system on a bigger scale before finalizing the Volcker Rule. A proposal of his own through the Committee of Capital Markets Regulation, an independent and nonpartisan think tank, calls for a more flexible approach to determining whether an investment is intended to profit from short-term price movements. Using agreed-upon metrics, it would be up to bank supervisors, working with their supervised institutions, to judge whether trades outside the guidelines are permitted given the circumstances they occurred. Over time these guidelines would be further refined based on their experience.
“Rather than putting this in the form of a rule, the supervisors would put it in the form of guidance to the banks as a starting point for any bank to say, ‘I'm outside your guidance, but there is a really good reason for it, and this isn't a proprietary trade,'” Scott says, explaining that an institution would have a chance to defend the trade.
Scott concedes that critics will question the trust placed in supervisors, charging that “they could cozy up to the banks.”
“But we rely on supervisors to supervise lending,” he says. “We don't write rules for which loan can you make, to whom, and for what amount. That's part of the bank supervision process and the risk from lending is far in excess than the risk from proprietary trading. We already entrust the supervisors with the major risks at the bank, we want to add onto that process to give them the power to decide what proprietary trading is.”
Resurrect Glass-Steagall?
Rather than trying to shape less onerous rulemaking, some say it doesn't go far enough and want to replace it with measures that are even more restrictive.
VOLCKER RULE IMPLEMENTATION
The following is a statement on implementation of the Volcker rule issued on Nov. 1 by the Committee on Capital Markets Regulation, an independent and nonpartisan research organization dedicated to improving the regulation of U.S. capital markets.
Section 619 of the Dodd-Frank Act, often referred to as the Volcker Rule, is designed to strengthen the financial system and constrain the level of risk undertaken by banking entities that benefit from FDIC-insurance on customer deposits and access to the Federal Reserve's discount window. The challenge to regulators in implementing the Volcker Rule is to prohibit the proprietary trading that Congress intended to limit, while allowing banking organizations to continue to engage in investments not intended to profit from short-term price movements, and in three forms of other permissible activities: hedging, market making and underwriting.
Alternative Proposal
We do not believe that it is possible to define with precision the line between proprietary trading and the three permissible activities. Either one risks too limited or too broad a definition of proprietary trading. A too limited definition would not prevent the trading that Congress sought to prevent, while a too broad interpretation would prohibit activities Congress sought to allow.
We recommend that an approach similar to the flexible approach used with respect to investments be used to determine whether the purpose of a trade is hedging, market making or underwriting. We propose that the Proposed Rule set forth guidelines for making this determination. These guidelines, while recognizing that some “customers” or “market-making trades” may give rise to excessive positions over a more extended period, would enable management and supervisors to determine a pattern of proprietary (or speculative) positions. Metrics should be developed to assist in that determination. Ultimately it would be up to bank supervisors, working with their supervised institutions, to judge whether trades outside the guidelines were permitted given the circumstances under which they occurred.
Bank supervisors would monitor risk limits and controls and over time the guidelines could be further refined based on experience. We agree with Chairman Volcker that “success is strongly dependent on achieving a full understanding by the most senior members of the bank's management, certainly including the CEO, and the Board of Directors, of the philosophy and purpose of the regulation. As the rules become effective, periodic review by the relevant supervisor with the Boards and top management will certainly be appropriate, as a key part of the usual examinations process or otherwise.”
Source: Committee on Capital Markets Regulation.
Former Delaware Senator Ted Kaufman, who was among those who voted in favor of the Dodd-Frank Act, wants to scrap the Volcker Rule and instead bring back the Glass-Steagall Act, which places restrictions on commercial banks from engaging in investment banking and other securities activities. The chair of the Congressional Oversight Panel thinks Glass-Steagall, a Clinton-era casualty of deregulation, could help solve the too-big-to-fail problem since it would likely force banks to separate commercial banking and investment banking into separate entities. “I think it is quite clear, even after Dodd-Frank, that banks are still too big to fail,” Kaufman says. “In fact, they are much bigger than the last time they failed.”
“The Volcker Rule is an example of one of those things that happens in legislation where half a loaf is better than none,” Kaufman says. “But sometimes half a loaf isn't worth very much. After watching this thing go on for more than two years, it is clear that that the federal government has to go back to Glass-Steagall.”
Scott, however, dismisses any speculation of a return to Glass-Steagall as both fanciful and wrongheaded. There was a major loophole in it, he says. While it prohibited any securities activities in the bank, such as underwriting, it also allowed these otherwise prohibited securities activities and proprietary trading in an affiliate of the bank, so long as it wasn't the principal activity of that affiliate.
Scott says many banks created affiliates for their trading of government securities. “They got a big number from doing that and then they could put into the same affiliate underwriting and proprietary trading, as long as it didn't add up to roughly 25 percent of the gross earnings of the entire affiliate,” he says. “One of the major reasons that Glass-Steagall was repealed was because people saw it was already being repealed in the marketplace by the use of these affiliates.”
Andrew Stoltmann, a securities attorney and shareholder advocate, is hopeful that as President Barack Obama's second-term regulatory appointments fall into place there will finally be a “Volcker Rule with some real teeth and one that doesn't allow there to be the massive carve outs for hedging that the securities industry is looking for.”
“There's a lot still up in the air, but having the Democrats strengthen their majority in the Senate, and the Republicans losing some house members, bodes well for the Democrats being able to run with their version and interpretation of things like the Volcker Rule, ramming it into existence,” he says.
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