The Volcker Rule is Already Principles Based

(Guest Post By Wally Turbeville of Demos)

The same message is repeated day after day by opponents of the proposed regulations implementing the Volcker Rule, and sometimes by those who should be sympathetic with its purpose.  They say that the proposal is too prescriptive and complex and should be pared down to a statement of principles.  The proposed regulations are by no means perfect, a fact that is not surprising given the scope of the Volcker Rule.  But these imperfections in no way justify abandonment of the work done by the regulatory agencies to implement Section 619 of the Dodd-Frank Act.

The statute sets out a fundamental redirection of financial services industry.  Banks that are insured by the FDIC and have access to the Fed window are prohibited from proprietary trading and investment in hedge funds, business lines that had grown dramatically in recent years.   The purpose is to eliminate risky trading market activity by institutions that enjoy the Federal safety net and are therefore far more likely to be too-big-to fail.  The rule would also go a long way toward breaking up the oligopoly of banks that dominate many markets because of their massive and subsidized capital bases.

The rule affects many of the largest participants in the securities and derivatives markets.  This is because of the distorted structure of the industry that was the result of the financial crisis.  The surviving investment banks were either absorbed by insured institutions or were converted to banks.  The Volcker Rule will mean that independent investment banks and other institutions not supported by the Federal safety net will absorb the prohibited business, assuming that it is profitable without the subsidy of the safety net.

The proposed rule release document setting out the proposed regulations is indeed a daunting read.  The Federal Register release itself is about 127 pages, though the rules are no more than 13 pages long with an additional 12 pages of appendices on detailed metrics, descriptions of processes and similar matters.  Even those who are sympathetic to the concept ask why the rules cannot be expressed as a simple statement that proprietary trading is forbidden.  We will all know proprietary trading when we see it, the logic goes.

In reality, the basic ban on proprietary trading is not too far from that.  It describes the activity in relatively simple and familiar terms (relying on the familiar concept of trading accounts) and then establishes a “rebuttable presumption” that positions turned over within 60 days are held for a proprietary purpose, basically the purpose of profiting from short-term price movements.  All this means is that the banks need to explain why positions that turned over in less than 60 days were not held for short swing profit reasons.

However, the statute does not stop there.  It excludes “market making” and underwriting, so as not to be too restrictive on banks.  Most of the complexity flows from these exceptions.  The reason is that over the period that banks traded in more and more reckless ways, generating massive profits and even more massive risks to their very survival, these relatively stable and low-risk business lines were contorted into vehicles for proprietary risk-taking.  The regulatory agencies were compelled to craft monitoring regimes to detect the potential drift toward camouflaged proprietary trading by the market making and underwriting desks.

Much of the attention is directed at market making, a function that traditionally involved customer service by facilitating access to trading markets.  The essential element is the existence of a market that provides reasonable assurance that the bank can cover the newly acquired position at a foreseeable price.  This function had been perverted by the banks into a customer sourced risk business providing access to positions for which no market existed.  These positions were taken on and held as bets that the exotic risks would pay off.  Underwriting, principally the facilitation of large offerings into the market for a customer, was similarly re-tooled into a means of marketing financially engineered securities and derivatives on behalf of the bank itself.

Hedging of otherwise permitted proprietary trading was also excluded from the prohibition.  Again, the regulatory agencies had to confront bank practices that involved the fabrication of exotic risks by offsetting positions with other positions that effectively created a new risk.  The excess risk embedded in the purported hedge remaining after the offset would be an altogether new risk position on the bank’s book.  Using this technique, a bank could take on a proprietary position properly as part of its market making.  The risk reducing “hedge” could offset the market making position, but also include excess risks that were even more dangerous that the underlying, market making position. This technique has commonly been used by traders to avoid internal rules against proprietary trading.  Again, the regulatory agencies were compelled address this practice of camouflaged proprietary trading.

The vast majority of provisions of the proposed regulations deal with these concerns by providing guidelines and monitoring techniques to detect a drift toward proprietary risk taking.  These are not hard and fast rules, but general characteristics that might arise if the Volcker Rule exceptions are being exploited improperly.  And the vast majority the text in the release is a discussion of the principles and a large number of questions designed to give the public, including the banks, ample opportunity to provide input.

The proposed regulations are simply not a draconian set of rigid and prescriptive rules.  They establish the principle of the prohibitions and the exceptions and then provide guidance so that the regulated institutions can discern the contours of compliance.  There are some clear issues relating to the proposed regulations that are worthy of debate.  However, the general complaint that the rules are too prescriptive and create intrusive and overbearing requirements is simply a straw man that opponents have propped up merely to knock down.

This is a clever tactic, since the subject matter is arcane and unfamiliar to those not in the trading businesses.  However, it should be seen for what it is: even more cynical than it is clever.  The industry lobbying effort using this tactic is merely reinforcing the reputation, so well earned in the financial crisis, that the banks cannot be trusted.

Not Just Technical — The War on Derivatives Reform

Unregulated derivatives markets have been at the center of almost every major financial crisis of the past two decades, from the 1998 bailout of Long Term Capital Management to Enron to the catastrophic financial collapse of 2008. (A fuller list would include the implosion of Banker’s Trust and Barings Bank, the bankruptcies of Orange County and Jefferson County, and numerous more ‘minor’ scandals). Derivatives can allow almost unlimited exposure to speculative risks, and no financial regulatory regime can be secure as long as they remain unregulated.

But derivatives regulation is highly vulnerable to attack by industry lobbyists. The technical details can be complex, and are understood by few outside the industry. So it’s easy to disguise major loopholes as ‘technical amendments’ or ‘clarifications’, even if the changes would seriously weaken or even destroy the capacity to regulate derivatives. Adding to the problem, the agencies responsible for derivatives reforms – the tiny Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) — are comparatively small and, unlike the banking regulators, depend on Congress for funding.

Industry lobbyists are trying to capitalize on this vulnerability through a coordinated assault on derivatives reform. One element of this attack is the so far successful effort to deny adequate funding to the CFTC, a key derivatives regulator. Another is a set of bills currently working their way through the House.

This legislation is usually presented as minor technical or clarifying changes, but that’s far from the truth. For example, the “Swaps Jurisdiction Certainty Act” (HR 3283) would make a huge range of derivatives reforms almost impossible to enforce by allowing big banks to evade derivatives regulations any time they deal through their foreign subsidiaries. Major banks have hundreds and sometimes thousands of foreign subsidiaries, and currently do more than half of their derivatives business through foreign affiliates. So such evasion would not be difficult. HR 2586, also being presented as a minor clarification, would make it almost impossible to achieve a significant goal of derivatives reform — ensuring fair price competition and full customer transparency in derivatives dealing. Under HR 2586 regulators would be banned from enforcing basic price transparency requirements at new derivatives exchanges. These bills have passed the House Financial Services Committee with some bipartisan support.

Another bill, HR 3336, has already passed the house by a 312-111 vote. Sold as a technical amendment that would assist small business, it would in fact eliminate key oversight rules for banks doing up to $200 billion in interest rate derivatives, global oil companies who do swaps trading, and other big financial players. Two other bills – HR 2779 and HR 2682 – are somewhat less sweeping but still have the potential to create real weaknesses in derivatives oversight. That’s particularly true in the case of HR 2779, which bans any regulation of swaps between affiliated companies.  This legislation has already passed the House with large majorities.

It’s striking that a number of these bills include such sweeping language that as originally drafted  they would have made it difficult to enforce not just new reforms but even pre-2008 prudential regulations on bank activities. This made someone nervous enough that sponsors added ‘reservations of authority’ language stating that key banking regulators such as the Federal Reserve would not be bound by the legislation when enforcing longstanding banking laws. It’s possible that this made some regulators less worried. But of course it leaves in place the damage to new derivatives reforms. If pre-crisis regulation had been sufficient we wouldn’t have needed reform at all.

Opponents of reform hope to pass off these major loopholes as unimportant technical amendments and potentially win large bipartisan majorities in the House. Although House bills passed on a partisan basis receive little attention, the hope is that a bipartisan majority would force attention to these bills in the Senate. But even amended versions of some of these measures would represent a significant setback. Consideration of these bills is also intended to intimidate the regulators as they work to complete derivatives rules. The experts at the regulatory agencies are supposed to work in a non-political environment, but they are now under fierce pressure from industry lobbyists. We’ve already seen cases where industry lobbying severely weakened regulations between the initial proposal and the final rule. A show of force in Congress increases the political pressure.

Fortunately, this is a battle we can win. All that’s necessary to stop this assault in its tracks is for Congressional supporters of reform – as well as the Administration — to hold firm and speak out in support of the common-sense derivatives oversight regime passed in law, and give regulators time to implement it. A bill that passes by a relatively narrow or partisan majority in the House is likely to die unnoticed in the Senate. It’s disturbing to see legislators of both parties, even some who in the past have supported reform, signing on to some of these bills or indicating their willingness to support them with amendments that could leave dangerous provisions still in place. We need legislators to stand up for the public interest, defend the derivatives reforms in Dodd Frank, and to let regulators do their job of implementing them. Join AFR’s mailing list or contact us at to learn how you can help.