Volcker Rule Rollback Inbound – Return of the Traders and Too Big to Fail?

This is not investment advice. The author has no position in any of the stocks mentioned. WCCF TECH INC has a disclosure and ethics policy.

It wasn’t so long ago that I wrote about the possibility of the Volcker Rule being rewritten and essentially watered down (here). Now we start to see some of the first shoots from those seeds as the Fed published yesterday its initial proposal (approved unanimously by the Fed’s 3 member board) to simplify restrictions on proprietary trading by banks. This comes among a raft of US financial regulatory loosening, including the recent reclassification of banks for the main Dodd-Frank piece of flagship legislation the US passed in the wake of the 2007-08 financial crisis.

Some of the changes to Dodd-Frank were probably overdue. Regulatory compliance can be an expensive and time-consuming affair. Smaller institutions had struggled with it since its introduction and in many cases arguments were appropriately made that the burden of compliance was too heavy on institutions which shouldn’t particularly have been targeted. However the Volcker Rule is a different beast altogether. Specifically designed to try to stop the riskiest activities of investment banks being undertaken with federally insured deposits and thus from putting the taxpayer on the hook for bailouts which are avoidable if the banks behave themselves.

Volcker was bitterly opposed in the financial services industry at its inception and has been heavily lobbied against by Wall Street ever since it was introduced. The obvious jump in bank stock prices in the wake of the Trump election win was a clear indicator that Wall Street had just found a friend in the shape of the incoming President and could be expected to resume normal service somewhat for the first time since the Dodd-Frank/Volcker Rule era began. Many will no doubt applaud the changes and undoubtedly a lot of money will be made, there are however major questions that arise from the shackles being removed.

Volcker Rewrite Proposal – Key Differences

Without going into too much detail of the 373 page document (here), the main highlights mentioned in the open Fed Board Meeting yesterday include:

The classification of banks into 3 tiers with differing requirements

  • Tier 1: Banks with over $10 bn in trading assets and liabilities, comprising approximately 95% of US trading activities governed by the rule (18 institutions) requiring the most stringent compliance level.
  • Tier 2: Banks with between $1 bn and $10 bn, comprising approximately an additional 3% and requiring simplified compliance.
  • Tier 3: Banks with less than $1 bn and with presumed compliance and no obligations under the new proposed rule.
Yeah, these guys will likely benefit...

This of course makes some sense. Worryingly, some of the changes which apply to the top tier institutions make less sense.

  • Trades which take place in less than 60 days will now be presumed to comply so long as they are within an appropriate P+L threshold (laughably, apparently the regulators think that banks avoid doing certain trades that they should within the 60 day threshold to reduce compliance costs!)
  • Hedging trades eliminate the need for quantitative analysis and documentation under the newly proposed rule.
  • A presumption that market making and underwriting activities are in compliance with Volcker as long as they are subjected to internal risk limits.

Ridiculously, the last point (if implemented) would require no mandated or specific analysis!

Volcker Watering Down - Are we forgetting the lessons of the past?

The board meeting makes for an interesting watch. Entirely scripted of course with the exception of a few softball questions at the end. For those interested, it’s only half an hour long and if you want the juicy details, you should start at about 12 minutes in (here).

The entire display seems specifically designed to attempt to reassure whoever may be watching that this isn’t a return to the bad old days of pre-crisis banks with proprietary trading desks taking massive bets on the market and yet much of the substance flies in the face of that assertion. Also somewhat contradictory was the statement towards the end that the Volcker Rule as it stands now, has “not materially disrupted liquidity provision in key markets”. A basic assertion of Wall Street lobbyists as the major complaint is that banks can’t do their job of greasing the cogs of the economy because they are shackled by Volcker. If Volcker isn’t harming economic activity, does it really need to be rewritten?

Many are hoping for Trump to repeal Dodd-Frank or at least the the Volcker Rule...

Fundamentally, many people misunderstand the point of regulation. Regulation is absolutely not perfect and generally won’t be. It is based on the premise of continuous improvement and over time will get refined, generally in reaction to market abuses and issues that arise in the real world as it attempts to resolve problems which have occurred and prevent them from occurring again, or in such a bad way. Was “too big to fail” really wiped out by the implementation of Dodd-Frank and the Volcker Rule? Probably not. Was it made less likely to occur again? Probably.

Wrapping Up

I suppose the fundamental problem I have with what is being proposed is that the burden of following the rules and demonstrating this has been shifted to the very institutions which brought the financial crisis about in the first place. A prescriptive rule set was implemented because it was felt to be the best way to stop banks from abandoning best practices in the competition for profits. If banks couldn’t be trusted to set their own risk limits before, why should they now?

Does the average person on Main Street understand the difference between hedging and taking a proprietary position? Unlikely. I’m sure it won’t be that easy to pull the wool over regulators eyes but are banks going to be able to baffle regulators with heavily structured trades which are claimed to be a hedge or part of an overall risk position limit which is in line with the banks expectations of realistic client demand? Probably. Additionally, the concept of CEO attestation of compliance for top tier organisations feels like a showcase rather than anything meaningful. I’d be surprised if a CEO personally went to jail because someone on a centralised dealing and risk management trading desk made a bad trade and put the bank at risk.

It feels like the fox has been given the keys to the hen house and told to make sure everything is good and pinky swear that they won’t be naughty. The trading arms race is about to start ramping up. The good news is that much of the latent technical ability of the financial services industry is about to be ramped up and put to good use doing what it does best. Dreaming up the best ways to make money. They’ve just been thrown a lifeline, hopefully it won’t come at the cost of the American taxpayer.