How Will the Volcker Rule Stand Up Against the Armies of Wall Street?

When the long-awaited Volcker Rule finally emerged last week, the outside world took out its magnifying glass. The advance buzz had said it would be “tougher than expected.” But soon enough, critics were poring over the text, spotting weaknesses, comparing notes, and even, in a few cases, calling it things like “Washington’s latest bonanza for lawyers and lobbyists” or the “one of the great pieces of Swiss cheese in regulatory history.

The grounds for concern are real. This was a committee product, shaped by 22 principal negotiators representing five agencies, dogged every step of the way by powerful and determined Wall Street lobbyists. At the same time, it is worth a cheer that the rule got done at all, thanks to the vigilance of advocates and recent prodding by Treasury Secretary Jacob Lew, among other things. Too often, rules opposed by industry can languish indefinitely, sometimes even for decades. We should also be grateful that those 22 principals included supporters of a strong rule who were able to insist on important improvements as the process came down to the wire.

While the final rule includes a number of gray areas, its clear intent is to curtail the ability of banks to use their government guarantees and inside advantages to engage in speculative activities for their own gain. If properly implemented – a big if, to be sure – the Volcker Rule could make it much harder for banks to gamble with taxpayer-backed funds, significantly reducing their ability to extract wealth from other areas of the economy, foment asset bubbles and leave the rest of us on the hook for the bets that go wrong.

The old regime of financial regulation – the one that slowly came apart in the decades leading up to the 2008 meltdown – dealt with this problem in a cleaner way. Under the Banking Act of 1933, also known as the Glass-Steagall Act, commercial banks, which take deposits and make loans, were ordered to get out of the business of investment banks, which package and trade securities. End of story.

Now, as then, a strong case can be made for keeping these lines of business separate; indeed, a worthy bill entitled the 21st Century Glass-Steagall Act was recently introduced by Sens. John McCain, R-Ariz., Elizabeth Warren, D-Mass., Maria Cantwell, D-Ore., and Angus King, I-Maine. But when the Dodd-Frank financial reform law was being hashed out in 2009 and 2010, Congress was not ready to take that step.

In fact, when the deliberations got underway, it looked like Dodd-Frank might do little or nothing to directly restrict securities speculation by banks. The Volcker Rule, proposed by former fed chairman Paul Volcker, made its way into the legislation only after a series of devastating revelations of dishonest securities marketing by banks which had abused the trust of their clients. Even then, success came only after a major battle led by Sens. Jeff Merkely, D-Ore., and Carl Levin, D-Mich., with a broad coalition of financial reform groups standing behind them.

By its nature, the Volcker Rule was bound to put a heavy burden of responsibility on the regulators and their decisions. That’s because the securities trading activities that the rule allows – hedging, underwriting, and so-called market-making – tread close to (and could easily become a cover for) the “proprietary trading” that it prohibits. It’s also because the big banks command an army of highly paid and skilled lawyers who stand ready to turn the smallest ambiguity into a “London Whale-size” loophole.

Indeed, they are at it already. The law firm of Bingham McCutchen held a Volcker rule “boot camp” for its attorneys last week, according to Bloomberg. At another big firm, Jones Day, some 200 lawyers were said to be working overtime to “make sure we have our arms around the content of the rule,” as one partner explained.

The regulators will have to stand up to that army, not just once or twice but for the long haul, trade-by-trade and deal-by-deal. They’ll have to be willing to incur the industry’s wrath and withstand the inevitable predictions of economic Armageddon. Modern history abounds with instances in which regulators have buckled before this kind of assault.

But if we look back, we can also find cases in which regulation has worked to make markets safer and more credible. From the 1930s into the 1980s, for example, U.S. banking and securities regulation worked remarkably well, restoring the credibility of an industry that had sold the country down the river in the 1920s, and laying the groundwork for nearly half a century of unprecedented financial stability.

In its final form, the Volcker Rule gives regulators a usable set of tools for making sure that banks limit their speculative activities. And some of the agency heads who signed off on the rule were refreshingly quick to acknowledge the importance of vigorous follow-though.

“The [Office of the Comptroller of the Currency] will be especially vigilant in developing a robust examination and enforcement program that ensures our largest institutions will remain compliant,” said Comptroller of the Currency Thomas J. Curry, speaking for an agency known as an industry pushover in the pre-crisis years.

Much the same point was made by Ben Bernanke of the Fed, which has its own shaky history to live down. “The ultimate effectiveness of the rule,” Bernanke said, “will depend importantly on supervisors, who need to find appropriate balance, while providing feedback to the board on how the rule works in practice.”

Regulatory feedback will be crucial – feedback not only to agency heads and directors, but to the wider world as well. The complexity of this rule makes transparency especially important. To keep the process of enforcement from disappearing into closed-door arguments between bank lawyers and bank overseers, the public must be able to see exactly how bank behavior has changed or not changed, and what the regulators are doing about it. That will require hard data on bank trading practices. One prominent economist has called on regulators to establish a public ‘audit trail’ that would release full trading data on a delayed basis. That’s the kind of information that would truly make it possible to tell how well the Volcker Rule is working.

There was considerable public interest in the writing of the rule, and it was encouraging to see many footnotes in the official discussion citing the opinions of the handful of public-interest organizations that weighed in (along with many banks and bank-connected law firms). Traditionally, bank regulators have been anything but champions of transparency; and since the Volcker Rule’s release, they have said little about how or even whether they propose to keep the public posted on the progress of implementation.

To hold the industry accountable, the regulators will need to move beyond the closed-door approach that has been their comfort zone. To hold banks and regulators alike accountable, the rest of us will have to go right on pushing on those doors.

— Jim Lardner

Originally published on

The Volcker Rule Is Already Having An Impact

It hasn’t taken long for the final Volcker Rule to send ripples through the financial markets – specifically through markets for asset backed securities. These markets  were famously used to package and sell the subprime ‘toxic assets’ that contributed so much to the financial crisis. Although the mortgage securitization market has shrunk greatly thanks to the disastrous record of mortgage backed securities during the crisis, securitization remains significant in other areas. Industry lobbyists are trying to portray these impacts of the Volcker Rule as somehow unintended or accidental. But in fact the Volcker Rule was intended (and properly so) to affect banks involvement in securitization markets, which were central to the 2008 crisis.

The Volcker Rule’s impact on securitization doesn’t result from the widely publicized provisions on speculative trading. It comes from the part of the rule that forbids bank investments in external funds, like hedge funds. These provisions are at least as important as the more widely discussed restrictions on speculative proprietary trading. Restrictions on external investments are necessary to make speculative trading controls work. If investments in external funds aren’t controlled, banks can just do their speculation at one remove, in ways that are more difficult for regulators and counterparties to understand. And there’s no question about the relevance of these restrictions to the financial crisis. Opaque and non-transparent connections between major banks and external entities like hedge funds and securitization vehicles were central to the problems at major banks during the 2008 financial crisis.

The Volcker Rule’s definition of an external fund includes the ‘special purpose vehicles’ used to organize securitizations. (The vehicles are essentially trusts that hold the loans or other assets backing a securitization). That means that without specific exemptions granted by the regulators, banks won’t be able to own asset backed securities or play a central role in securitizations. In the final rule they just passed, regulators granted such a special exemption. But the exemption is only intended to accommodate ‘plain vanilla’, relatively simple securitizations where special purpose vehicles hold only loans and a limited range of derivatives.  These kinds of securities can still be quite risky, and there’s an argument that regulators already went too far in their exemption. But the exemption would still rule out many of the more complex securitizations that were important triggers of the financial crisis.

The first wave of public industry opposition to the final rule is coming from banks who own such complex securitizations. This week, a wave of lobbyists hit the Hill to decry the Volcker Rule’s impact on banks who own ‘Trust Preferred CDOs’ (a securitization called a Collateralized Debt Obligation, or CDO, that holds Trust Preferred Securities, or TRUPS).

The history of the Trust Preferred CDO market offers a tour of the worst aspects of the pre-crisis financial system. Trust Preferred Securities took off when banks tried to circumvent limits on borrowing by issuing a kind of debt dressed up to look like loss-absorbing capital – essentially promising creditors reliable payments while telling regulators that payments to creditors could be cut off if the bank ran into trouble. Since, unsurprisingly, it was difficult to find investors willing to take this deal, banks trying to sell TRUPS asked Wall Street investment banks to design CDOs that bundled the securities into a product that could be sold as less risky than the basic security. The investment banks in turn pressured the credit rating agencies to certify their risky new CDOs as investment grade by using misleading performance assumptions. To make matters worse, many of these CDOs were purchased by other banks, doubling down on the already high risks of the instrument. (All the gory details are available in this paper).

Thanks to Senator Collins and then-FDIC chair Sheila Bair, strong controls were placed on new TRUPS issuance in the Dodd Frank Act. But about 200 banks – some 3 percent of all U.S. banks — still hold old TRUPS CDOs, which have suffered huge price declines. In many cases their regulators have none the less permitted them to hold these CDOs at historical prices rather than marking down losses based on current market prices. Since the Volcker Rule will force the sale of these assets by 2015, banks that bought them in the past may now have to sell and suffer losses. That’s unfortunate in the case of community banks, since smaller banks who purchased such CDOs were in some ways victims of the Wall Street securitization complex. And it may be possible to work out a way of grandfathering these legacy assets. But it’s crucial that neither regulators nor Congress undermine the Volcker Rule controls on securitization just to ease this transition period.

A second wave of opposition to the new Volcker Rule controls is coming from participants in markets for Collateralized Loan Obligations (CLOs). CLOs generally hold ‘leveraged loans’ made to corporations who do not have strong enough credit to directly issue bonds. (Many of these leveraged loans are used to fund private equity takeovers).  The CLO market is now considered one of the riskier securitization markets around, as leveraged loan practices have been targeted for numerous regulatory warnings over the past few years. Once again, it seems like controls on this market might not be a bad idea. While CLOs that hold only loans can qualify for the existing Volcker Rule exemption, it turns out that many CLOs hold a range of other non-loan securities and thus won’t be permissible holdings under Volcker.

Last night, regulators issued a guidance reiterating the terms of their securitization exemption, and pointing out that financial engineers might be able to find ways to make complex securitization products fit within the terms of that exemption.  While that’s not totally reassuring, it still indicates that the regulators are willing to hold to the limits they just created on bank involvement with potentially toxic securitizations. That’s the right approach. Those limits aren’t an accident – they’re one of the central new protections created by the Volcker Rule.

Going After the Modern-Day Loan Shark

When financial regulators do something right, it should be noted.

Two weeks ago, the Federal Deposit Insurance Corporation and the Office of Comptroller of the Currency did something very right: They issued a joint guidance document that bans abusive payday lending by the thousands of banks they oversee. Unfortunately, the Federal Reserve did not do the same, so the banks it regulates can continue to make these loans.

In April, when the FDIC and OCC first came out with their proposal, financial industry lobbyists raised a storm of protest. The result, they warned, would be to drive people back into the arms of storefront loansharks.

Indeed, payday lending was a storefront industry until a little over a decade ago, when a handful of banks began offering so-called “deposit advances.” As multiple studies have shown, however – and as the two regulators affirmed last week – these offerings bear all the trademarks of the worst payday loans, including high fees, lump-sum repayment within a few weeks, direct lender access to borrowers’ deposit accounts (and income streams), and the tendency for one loan to become a cascade of loans at the equivalent of triple-digit interest.

The banks are charging that interest, moreover, to their own account-holders, and specifically to those with direct deposit and a record of steady earnings – hardly a high-risk customer base.

Consider the Senate testimony of Annette Smith, a 69-year-old California woman who ended up paying $3,000 for what was essentially a single $500 loan from Wells Fargo. Smith had gone into the bank looking for a few hundred dollars to repair her truck. After explaining that Wells didn’t make loans on that small scale, a bank officer encouraged her to apply for a Direct Deposit Advance online. (Wells, like the other banks offering such products, avoided using words like “loan” or “interest” in its marketing.)

Smith testified that she had “never considered going to one of those payday loan stores because I knew they had a reputation for charging really high interest rates that I could never afford.” Mistakenly assuming that a major bank wouldn’t do that kind of thing, she “went home and with just a few clicks, received $500 into my account.” And “a couple of weeks later when my Social Security check was deposited electronically to my account,” she continued, “the bank withdrew the $500 plus a $50 fee. Back then my monthly Social Security check was for less than $1,200. That means that the $550 that I paid Wells Fargo that month was about half of what I had to live on for the month. Without it, I could not afford to pay my rent and all my other bills and expenses. So, a few days later, I took out another $500.” Thus her $500 loan morphed into a five-year cycle of debt.

About half of all bank payday loan customers are, like Smith, retirees living on Social Security; and according to a study published by the Consumer Financial Protection Bureau in April, banks often seize monthly benefits before their customers can pay for food, prescriptions or other basic expenses.

The banks claim to be serving a particular set of customers – those with “an immediate expense that needs to be deferred for a short period of time and … sufficient influx of cash by the next pay period to retire the debt,” as the CFPB study puts it. And yet, the study adds, “it does not appear that lenders attempt to determine whether a borrower meets this profile before extending a loan.”

Under the new guidelines, banks will have to verify an applicant’s ability to repay without repeated borrowing, and no customer will be able to receive more than one loan in a two-month period. That boils down to “no more deposit advances,” since the business model depends on heavy repeat business. The typical borrower takes out 14 loans a year, the CFPB says.

Payday loans, regardless of where they are made, are designed to take advantage of people in desperate circumstances. Thanks to a long campaign of grass-roots activism, 14 states and the District of Columbia have passed laws limiting or prohibiting such loans. But with the Internet making it increasingly easy for lenders to operate across state lines, the struggle will have to be won in Washington too.

The Consumer Financial Protection Bureau, which has authority over bank and nonbank lending practices, will be a key player. In addition to its valuable research on the problem, the CFPB recently announced its first payday-loan enforcement action. The Dallas-based Cash America agreed to pay more than $19 million in refunds and fines for robo-signing debt-collection documents, violating a 36 percent interest rate cap for members of the military and destroying evidence. (According to the CFPB, a Cash America subsidiary had deleted recorded calls with consumers, instructed employees to conceal materials from regulators and shredded documents, even after being ordered to stop.) The next step for the CFPB is a rule dealing with abusive payday practices.

With the FDIC/OCC directive, the banking world is now split between one large group of institutions which cannot make payday loans, and another large group of institutions which can – because their regulator, the Fed, continues to permit the practice. Two of those banks, Fifth Third and Regions, are currently in the payday-lending business.

Last week an alliance of community groups delivered petitions in which more than 12,000 people (including many supporters of National People’s Action and Americans for Financial Reform) called on Regions Bank to drop its “Ready Advance” loans, which come with a $2 cash advance fee for each $10 borrowed. The groups also staged protests outside Regions Bank offices in Decatur, Ill. Columbia, Mo., and Urbandale, Iowa, where the rally featured a spokesperson in a shark suit.

Regions, like Fifth Third, could decide to do the decent – and reputation-protecting – thing by discontinuing these products without being ordered to do so. As long as the Federal Reserve continues to offer a safe haven, however, there’s not much likelihood of that. And other banks may be tempted to get into the game. Who knows where the shark suit will show up next.

— Jim Lardner

Originally published on