Final Volcker Rule limits on bank trading released by regulators

[No1]

http://www.washingtonpost.com/postt...09f768-61bb-11e3-8beb-3f9a9942850f_video.html

--> 2 minute video for those that don't remember the history of the rule or what it's for.

Government regulators unveiled a sweeping rule Tuesday to prevent big banks from trading for their benefit rather than on behalf of customers, three years after the Obama administration called for the measure.

The “Volcker Rule,” named after former Federal Reserve chairman Paul Volcker, bars banks from making trades merely for profit and prohibits them from owning hedge funds and private-equity funds. The centerpiece of the 2010 Dodd-Frank financial overhaul law took years to complete as government infighting and intense lobbying by banks slowed the process.

Lawmakers devised the measure to prevent banks with government backstops such as deposit insurance from making risky trades for their own benefit, because the bets could endanger taxpayers. The challenge for regulators has been restricting such proprietary trading without impeding acceptable practices, such as firms trading on behalf of clients as market-makers or hedging their risk against fluctuations in interest rates.

On Tuesday, the Federal Deposit Insurance Corp. board as well as the Federal Reserve unanimously approved the final version of the rule. The Securities and Exchange Commission voted 3 to 2 in favor. The Commodity Futures Trading Commission canceled a public vote on the rule due to the snowstorm, but said it would adopt it behind closed doors.

Supervision will ultimately be the responsibility of the Office of the Comptroller of the Currency, the CFTC and the SEC.

“Issuing a final rule is only the beginning of the process,” said Comptroller of the Currency Thomas J. Curry, at the FDIC board meeting. “The OCC will be especially vigilant in developing a robust examination and enforcement program that ensures our largest institutions will remain compliant.”

The 71-page rule, a streamlined version of the initial 298-page draft, addresses many concerns about which activities and investments are allowed, but gives regulators flexibility for interpretation.

Institutions are allowed to take positions to help clients trade, but their inventories cannot exceed “the reasonably expected near-term demands of customers,” according to the final rule.

There are a host of requirements for bank to prove they are not engaging in speculative gambling, but acting to serve client needs or protect against market risks. The final rule also lifts the restriction included in the original draft on proprietary trading in foreign government debt.

A key part of the rule calls for firms to conduct an analysis and provide a rationale of their hedging strategy to prevent another “London Whale,” the $6.2 billion trading fiasco at JPMorgan Chase. That blunder in 2012 turned the tide of the debate as supporters of reform gained the upper hand in calling for tough restrictions on risky hedges.

As analysts anticipated, the Fed has extended the amount of time banks have to conform to the rule by pushing the deadline back a full year to July 21, 2015.

By then, banks will need to have to develop program to monitor compliance with the rules. The chief executives of large banks will have to attest in writing annually that their banks have a process in place to enforce, review and test the compliance program.

Institutions with at least $50 billion in trading assets and liabilities will have to report seven quantitative measurements, including the amount of risk that a trading desk is permitted to take at a point in time.

“The strength of the rule is the scope of the compliance regime,” said Marcus Stanley, policy director of Americans for Financial Reform. “The regulators correctly realized that most proprietary trading is hidden within supposedly innocent activities like hedging or market making.”

He said the rule offers guidelines that are only as effective as the regulators that implement them.

Dennis Kelleher, chief executive of Better Markets, which advocates for financial reform, added, “Make no mistake about it: Regulators now own the Volcker rule. They have to aggressively enforce it, ensure it is complied with or answer for any future blowups.”

In anticipation of the rule, many large banks, including JPMorgan Chase and Goldman Sachs, have shuttered or spun off their proprietary trading desks, as well as their private-equity arms and hedge funds. Still, industry groups worry that the Volcker Rule will sink profits at some of the nation’s largest banks and diminish the amount of capital in the markets.

“There is no doubt that, consistent with our experience in other rulemakings, questions will arise following today’s action, some of which will require clarification,” said SEC Chairman Mary Jo White, in a statement. “We must be alert to both unintended impacts and regulatory loopholes as we move forward.”

 

[No1]

There are six big arguments against the Volcker Rule. Here’s why they’re wrong.
Posted by Mike Konczal on December 10, 2013 at 11:56 am

Today is the day we finally get to see the Volcker Rule, the new regulation that aims to prevent banks from engaging in speculative trading activity. (See here for an overview.)

Paul Volcker, former chairman of the U.S. Federal Reserve. (Bloomberg)

In all the excitement, a lot of commentators have been writing posts arguing that the Volcker Rule is either unnecessary or perhaps even counterproductive. Both Matt Levine andTyler Cowen have summed up these cases well.

There are usually six different complaints about the Volcker Rule. By addressing them, we can lay out the case for why this rule is important and worth strengthening. I’ll take the complaints in order from least to most important:

1) “The Volcker rule isn’t a fix-all for Wall Street’s ills, and it might not even be a necessary component of reform. Why are we bothering to do this complicated thing?”

Let's back up: The Dodd-Frank Act included a series of reforms that were designed to reinforce each other. The ultimate goal is to build a financial system that helps the real economy while also both preventing future crises and having the correct tools to deal with crises when they do happen.

In order to limit the government’s need to act as a safety net during a crisis, regulators are creating various tools that try to do three big things: First, the financial sector will have to internalize some of the costs of crises and insurance. Second, there’s more supervision of banks through things like capital requirements. Third, there are limits on the sorts of activities the banks can do.

The Volcker Rule mainly focuses on the third component — it prevents banks from engaging in “proprietary trading,” which essentially removes the parts of banks that gamble and act like hedge funds, because those parts can blow up quickly (see here for more).

It’s also a conceptual and cultural shift: Banks need to be boring again and focus on their core business lines. As Marcus Stanley of Americans for Financial Reform wrote, the Volcker Rule creates “a new definition of the dealer or market maker role that is more stable and reliable due to the removal of proprietary trading incentives.” This role will still support lending and credit but will also create a new “reliable utility role for dealer banks in the financial markets.”

That’s all just to say that there’s no one single “fix-all” reform here. All three components of financial regulation need to hang together. That involves a well-capitalized banking sector with high leverage, liquidity, and risk-adjusted capital. It also involves a sane over-the-counter derivatives market. And it requires a credible mechanism to force losses on to investors at firms that were previously "Too Big To Fail." Those components have to work together.

2) “That’s fine, but seriously, this rule would have done nothing useful in solving the last financial crisis. It’s a solution in search of a problem.”

Perhaps. But “solving the last financial crisis” is only one of many goals here. There are other problems that the Volcker Rule does address, at least in part:

First, take resolution authority—the legal regime that’s designed to wind down very large banks and institutions that run into trouble. By preventing banks from engaging in proprietary trading, the Volcker Rule actually makes this task easier. Proprietary trading is notorious for creating quick, large losses, which makes it harder for regulators to deal with failing institutions (resolution authority typically involves nudging banks to better capital while giving regulators the tools necessary to take over failing firms—see more here).

The Volcker Rule also works in concert with other reforms, providing a backstop if those rules don’t work out. If derivatives regulations turn out to be insufficient, for instance, then the Volcker Rule still prevents large banks from carrying out huge bets on tail risk through the derivatives market.

The Volcker Rule would have also helped make the last financial crisis less extreme. “Certainly proprietary positioning played a role in the crisis,” says Caitlin Kline, a former derivatives trader who now works at the non-profit Better Markets. “Banks amassed inventories of high-yielding highly-rated products with largely overnight funding, and this street-wide carry trade helped cause a massive liquidity crisis and then solvency issues, which was a major factor. The Volcker rule will absolutely affect most front-office desk's ability to warehouse huge positions like that.”

This isn't the only goal of the Volcker Rule. (AP)

 

[88m3]

 

[No1]

3) “Sure proprietary trading might be dangerous, but so is lending money. In fact, lending money is even more dangerous, given the losses in the crisis, so why don’t you ban banks from doing that too!”

The problem there is that lending to households and businesses is the core function of banking. And there are good reasons why banks provide this service instead of other types of firms. For instance, funding increases as relationships between firms and creditors evolve (for more, see Fama 1985 or Petersen and Rajan 1994).

So other firms can’t easily do what banks do when it comes to lending. But other firms candefinitely engage in proprietary trading—including hedge funds, mutual funds, sovereign wealth funds and others. So if proprietary trading does have any benefits to society at large, there’s nothing to worry about. It will still take place. On the other hand, if banks are prohibited from lending, it’s not clear that other institutions could pick up the slack.

4) “Allowing banks to have more business lines allows them to diversify their income streams, which will, all things being equal, make the financial system more stable."

Neither theory nor evidence backs up this complaint. Financial theory tells us that we should distinguish between risks to individual firms and risks to the broader market. An economic crisis is the result of market-wide risks, and there’s good reason to believe that market-wide risk will go up as banks increase their business lines. That’s why the Volcker Rule is useful.

Diversification may reduce risks at each institutions, but it leads to the sharing of risks across institutions — different firms all become exposed to similar types of risks. That’s a problem, since it’s harder for regulators to tackle a variety of firms that all start failing at once. (For more, see Wagner 2006, De Jonghe 2009).

As Alexis Goldstein notes, “all the gains made by stand-alone prop trading desks from 2006–10 were entirely wiped out by prop trading losses” during the financial crisis. If diversification was a good thing, we would have seen these profits soar during the crisis. Instead, the desks all lost money at the same time, further exacerbating the crisis.

5) “The Volcker Rule will decrease liquidity and available financial services, making the financial sector more vulnerable and less able to meet the needs of the real economy.”

This is a concern, but the status quo wasn’t ideal on this front, either. During the last financial crisis, liquidity in the markets disappeared, which shows how vulnerable we are if liquidity is concentrated in a few large banks who have access to the safety net (seeRichardson).

The Volcker Rule is designed to allow banks to continue core functions like “market-making” — that is, matching buyers with sellers or acting as an intermediary by using financial instruments. Even so, some liquidity will move to other firms that don’t depend on the banking safety net, creating more competition. This is a perfectly appropriate response.

6) “It is impossible to distinguish between prop trading and the legitimate functions that firms are supposed to be able to still engage in, like market-making and hedging.”

This is the correct debate to be having. There are certainly some activities that are clearly considered “proprietary trading,” and banks will be barred from doing these. But there are real questions and gray areas surrounding activities that want to keep banks doing, such as market-making or hedging against risks. As discussed here, we’ll want to keep a close eye on how banks change after the rule is implemented. But the regulators see this as their job and are moving on the task.

So, rebuilding the core banking sector to be boring and focused on their core business lines, while mitigating systemic risks and enforcing other parts of reform. What’s not to like?

This is strictly for the nerds like me I suppose.

 

[Domingo Halliburton]

hold up, prop trading isn't allowed anymore?

 

[Domingo Halliburton]

and I think #5 is going to happen just not in markets your average person probably deals in.

 

[Brown_Pride]

hold up, prop trading isn't allowed anymore?

nope
no more proprietary trading, it has to be client related. I.e. banks can't be clients to themselves...


I wonder though, can banks be clients to other banks? e.g. loop hole?

 

[88m3]

nope
no more proprietary trading, it has to be client related. I.e. banks can't be clients to themselves...

I wonder though, can banks be clients to other banks? e.g. loop hole?

 

[Brown_Pride]

not an expert but they would be exposing themselves to all kinds of tom foolery and how would they cover losses?

i don't know how or that they even would cover losses i'm no banker, but i suspect if this law is like every other law then there is a loophole somewhere, I am just curious what it will be

 

[88m3]

i don't know how or that they even would cover losses i'm no banker, but i suspect if this law is like every other law then there is a loophole somewhere, I am just curious what it will be

I bet the large institutions role out smaller private banks again that have mostly been swallowed up after the mess of 07' and 08'.

@Domingo Halliburton

 

[Brown_Pride]

I bet the large institutions role out smaller private banks again that have mostly been swallowed up after the mess of 07' and 08'.

@Domingo Halliburton

yeah i was thinking the same thing, i wonder though is that covered in this legislation. Essentially the same money is being used for the same thing, i wonder if placing a middle man in between fixes that? It'll basically be creating SUPERPAC type banks but that don't spend money on politics, they spend money on gambling...?

*waits for someone smarter than him to answer these questions*

 

[88m3]

yeah i was thinking the same thing, i wonder though is that covered in this legislation. Essentially the same money is being used for the same thing, i wonder if placing a middle man in between fixes that? It'll basically be creating SUPERPAC type banks but that don't spend money on politics, they spend money on gambling...?

*waits for someone smarter than him to answer these questions*

There's something to be said about people who make digs at other peoples intelligence.

Insecure much?

 

[Brown_Pride]

There's something to be said about people who make digs at other peoples intelligence.

Insecure much?

i was referring to myself

 

[Domingo Halliburton]

the article was saying Goldman and jpm have spun off their prop desks. I'm sure they keep some sort of stake in them. I don't know though.

 

[Domingo Halliburton]

yeah i was thinking the same thing, i wonder though is that covered in this legislation. Essentially the same money is being used for the same thing, i wonder if placing a middle man in between fixes that? It'll basically be creating SUPERPAC type banks but that don't spend money on politics, they spend money on gambling...?

*waits for someone smarter than him to answer these questions*

There's going to be no more prop trading:

it's for hedging....