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.