Over three years in the making, a key piece of the Dodd Frank Wall Street Reform and Consumer Protection Act reaches completion and limits proprietary trading by US banks. Yet, the piece comes with risks of its own.
On December 10th, five US financial regulatory agencies adopted a final rule to enact the Volcker Rule, a major piece of the Dodd Frank Act, which limits trading by banks. The rule prohibits banks from conducting proprietary trading and from owning certain private equity and hedge funds. The goal of the rule is to prevent banks from using federally insured money to make trades for their own purposes.
Up until now, banks have been able to use deposited money to place bets on their own account in the market. The Volcker Rule bans this in the hope that the government will not be on the hook for future bailouts on risks that banks took for their own profit. In principle, this will make the financial system safer by discouraging certain risk taking. However, the now prohibited trades were not the primary cause of the financial crisis — banks can still make ill-advised loans. The effectiveness of the rule will thus depend on the attitude and interpretation of the regulating bodies, making it an excellent example of political risk.
Less strict than expected
The rule makes several key exceptions to its wider ban on proprietary trades. To preserve market functioning, activities considered to be market-making are still permitted. Banks usually keep an inventory of securities to meet the demands of investors wishing to buy or sell. This enables them to quickly fill orders for clients and improves liquidity within the system by making securities easier to trade. The Volcker rule preserves this bank practice but qualitatively limits banks to inventories which are correlated to “reasonable” customer demand.
Hedging positions continues to be permitted but with significant checks on the type allowed. Banks often aim to compensate risks by taking market positions that are negatively correlated. In other words, a bank would try to position itself so that a loss in one area would tend to lead to a gain in another related area. Yet, the Volcker Rule does compel covered banks to ensure that hedging “demonstrably reduces or significantly mitigates, specific, identifiable risks of individual or aggregated positions of the banking entity.”
This specification makes so called ‘portfolio hedging’ prohibited. Portfolio hedging usually consisted of banks making trades that bet against the direction of the market, or the profits/revenues of a sector. While banks can still hedge against an aggregate position, they have to identify to regulators exactly how the hedge reduces the idiosyncratic risk of positions held.
Up to the regulators
The Volcker Rule falls under the responsibility of five agencies: the Federal Reserve, the FDIC, the OCC, the CFTC, and the SEC. This makes the administration of the rule dependent on the ability of the agencies to cooperate and implement it effectively. Internal divisions between them disrupted the timely completion of the rule.
At one point, the Federal Reserve was reported to no longer be accepting comments from the other agencies. Secretary of the Treasury Jack Lew needed to make a forceful push to pressure regulators to finish this year. But for the Volcker Rule to be fair and uniform, the agencies will need to compare notes and be in agreement on their interpretations of the statute.
Terms like hedging and market-marking are demarcated by qualitative adjectives like “reasonable” and “identifiable.” These necessarily require interpretative decisions: Does that hedge really reduce an identifiable risk of a new position? Does a bank’s inventory reasonably meet consumer demand? Daniel Tarullo, a governor of the Federal Open Market Committee, recognized this issue and noted that the implementation will be the most important in shaping the Volcker Rule.
At the open Federal Reserve Board meeting after the promulgation of the rule, Ben Bernanke asked Fed staff how perfect a hedge needed to be to be considered a hedge. Clearly, the concern that a bank will never be able to perfectly hedge a specific risk was weighing on his mind. The five agencies will need to rely on heavy communication and cooperation between their respective staffs to ensure that they are all on the same page. While the Volcker Rule makes considerable gains in changing the risk structure of banks, its purpose will not be realized unless it is administered consistently and judiciously regardless of boom/bust economic cycles.
