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The Volcker Rule has at last been put into final form and adopted by financial regulators. The media has paid little attention to what this important rule would actually do, and many people might wonder why it took over three years for the regulatory agencies to reach agreement. The reason is simple: the rule prohibits proprietary trading by banks and their non-bank affiliates, but it also permits these same entities to continue the vital function of market-making and the equally vital function of hedging their risks. The activities involved in market-making and hedging — principally buying and selling debt securities — look a lot like proprietary trading. Drafting a rule that prohibits proprietary trading but permits market-making and hedging was devilishly difficult, and probably not possible without impairing one or the other.
In the end, it appears, the Obama administration — in order to finalize the rule — pushed drafters to tighten the restrictions on proprietary trading despite the risks of impairing market-making and hedging. This was a choice that reflects the Left’s preference for tighter regulation over efficient markets. Ultimately, it will impose costs on all companies, not just banks and their affiliates.
The Volcker rule is highly complex, and the issues that it raises have never been fully explored in public, let alone debated, while it was under consideration in Congress or among the responsible regulatory agencies. The easiest way to explain the rule’s underlying concepts and effects is in a question and answer format:
What is proprietary trading?
The misguided rule will impose costs on all companies, not just banks and their affiliates.
The rule prohibits what is called “proprietary trading” — that is, a bank or bank-related entity (like a bank holding company or a subsidiary of the holding company) buying or selling securities as principal for its own account and not for the account of customers. In other words, the financial institution has made a business of buying or selling securities when it sees favorable circumstances in the market.
What institutions are covered by the rule?
The rule was sold to the public as a way to prevent banks from using insured deposits to engage in “risky trading” for their own accounts. For example, after the approval of the rule, Treasury Secretary Jack Lew noted that President Obama proposed the rule “to put an end to banks’ ability to engage in high-risk activities solely for their own benefit, while enjoying the advantages conveyed by deposit insurance and other government protections.” This statement is best characterized as a half-truth. Because it also applies to “bank-related entities” it encompasses far more than insured banks. Moreover, referring to proprietary trading as a high-risk activity is misleading; as outlined below, proprietary trading is no riskier than lending.
Bank-related entities such as bank holding companies (BHCs) and the BHCs’ non-bank subsidiaries are all ordinary corporations that raise their funds in the capital markets. They have no access to insured deposits or the Fed’s discount window. What’s more, there are strong “firewalls” between banks and their BHCs and non-bank affiliates, so that these firms cannot use the bank or its insured deposits for their own purposes. Accordingly, while the public was told that the Volcker rule was intended to protect their insured deposits, it actually severely restricts the legitimate and valuable activities of non-bank affiliates of banks that pose no threat to a bank’s insured deposits. As we will see, these restrictions will be very harmful to the financial system and the U.S. economy.
Is proprietary trading especially risky? Was it one of the causes of the financial crisis?
While the public was told that the Volcker rule was intended to protect their insured deposits, it was actually restricting the activities of non-bank affiliates of banks that pose no threat to a bank’s insured deposits.
The answer to both these questions is no. It’s hard to see how trading securities is riskier than lending. When it lends, a bank commits cash to the control of another party for an extended period of time. The bank seldom has effective control over the way the borrower uses the funds — leading to the possibility of loss — and by lending the funds it has reduced the amount of cash it has on hand in case large numbers of depositors or other creditors want their money back. Trading securities, on the other hand, is simply buying and selling. There is of course always the danger that a bank’s inventory of securities will decline in value, but at least the banking entity has control over it at all times and can sell it quickly if it foresees adverse events in the future. Lenders can seldom recall a loan when they foresee problems for the borrower.
There has never been any evidence that the proprietary trading of securities had anything to do with the financial crisis. Indeed, it was not trading of securities, but investing in securities — particularly securities backed by subprime and other low quality mortgages — that caused the losses to the banks and other financial institutions in the 2008 crisis.
Why is the prohibition on proprietary trading so controversial?
Proprietary trading was profitable for the banks and their nonbanking affiliates. Profits make banking entities healthier and provide them with the funds and the confidence to make loans and expand their activities. Even if proprietary trading is looked upon as too risky for banks because they are funded in part by insured deposits, that is not true of their holding companies and other affiliates that have no access to insured deposits. In fact, it may be riskier to deny bank-related entities like BHCs the opportunity to engage in proprietary trading than to permit them to continue doing it. We all recognize that the economy is constantly changing and that businesses must change in order to remain viable. Bank-related entities face the same problem of adaptation to change. They were once the major source of financing in the economy; now they are dwarfed by the securities markets. Virtually all large companies in our economy now fund themselves by issuing securities — bonds, notes, and commercial paper — not by borrowing from banks. Companies have found that issuing debt securities is more efficient than borrowing from a bank. If regulation confines banking entities to the businesses they have always been in, rather than the businesses that are likely to be growing in the future, the banks will inevitably fail.
Proprietary trading, moreover, was the kind of financial activity for which banking entities were particularly well suited. It required them to understand the direction of markets, interest rates, and events that influence both — financial areas where they are natural and knowledgeable participants. By prohibiting this activity, the Volcker rule has now pushed banking entities back into a past that is quickly disappearing.
Why did it take so long for the Volcker rule to be approved?
There has never been any evidence that the proprietary trading of securities had anything to do with the financial crisis.
As noted earlier, while the Volcker rule prohibited banking entities from proprietary trading, it permitted them to continue to engage in two other vital activities: market-making and hedging transactions. Both are made far more difficult by the Volcker rule, and I suspect that the reason was the reluctance of the bank regulators to impair either of these vital activities.
Market-making is just what it sounds like: creating a place where buying and selling can occur. The stock market is an example of a market where trading occurs, but the stock market has vast numbers of buyers and sellers — when a seller appears there are almost always buyers. However, the market for debt securities is thin. Although the debt market is much larger in dollar size than the equity markets, its trading is much thinner. There are several reasons for this, but important among them is the fact that major investors like insurance companies and pension funds buy debt securities to hold them to term and earn interest, not to trade them. So if a pension fund decides that it wants to sell a debt security, it cannot readily find a buyer ready to bid. This can mean very long delays in receiving the necessary funds to make pension or other payments, or taking a sharp cut in the value realized on the sale when a buyer is eventually found.
In acting as market-makers, banks and bank-related entities serve as important intermediaries; they buy bonds from sellers and sell bonds to buyers. In other words, banks and bank-related entities are the lubricants of the debt markets; they make it work by acting as principal intermediaries between buyers and sellers. Without them, the search costs for buyers and sellers would be very large. The “spread” between the bid and ask prices for the bond would be much wider, and that means it would cost firms more to buy a bond and they’d get a lower price when they sell it. If this becomes the regular pattern in the market for debt securities, it will be harder for companies to meet their cash needs by issuing these securities.
If we recall now that the Volcker rule prohibits banks from trading securities for their own account, we can begin to see the problem. Market-making sounds a lot like proprietary trading; the bank has a portfolio of bonds, which it is offering to buy or sell for its own account, but that’s the very definition of proprietary trading. How does one tell the difference between proprietary trading, which is forbidden, and market-making, which is vital to the markets and permitted by the rule? The difficulty of drawing that line in a regulation was what stopped the regulators who were charged with drafting the rule. They probably realized that they could seriously impair the debt markets if they drafted a rule that impinged excessively on market-making, and were reluctant to do so. But, eventually, under criticism from the Left that a major provision of the Dodd-Frank Act was stalled, and statements in the media that the banks were weakening and delaying the Volcker rule, the political masters in the White House and Treasury forced a decision in favor of a “tough” rule — one that favored prohibiting proprietary trading over permitting market-making. It should not be surprising; this administration could not stand a headline that said they had weakened the Volcker rule to please the banks.
If regulation confines banking entities to the businesses they have always been in, rather than the businesses that are likely to be growing in the future, the banks will inevitably fail.
The danger to the markets now comes from the chilling effect that the rule will have on market-making by bank-related entities. Recently, JPMorgan Chase, one of the most respected banking entities in the United States, settled a number of alleged violations of banking rules by paying the enormous sum of $13 billion. The chairman of the bank kept his job because he continued to have the confidence of the board of directors. But imagine if you were functioning as a market-maker for a banking entity. Could you be certain that trades you were making in buying and selling a security would not be re-characterized by the regulator as proprietary trades? If that happens, it’s likely your employer will have to pay a hefty fine and suffer bad publicity as a rule-breaker. You would soon be looking for another job.
It’s not that the banking entity or its personnel can’t follow the rules; it’s that the rules are inevitably ambiguous — the explanatory material that goes with the Volcker rule is almost 1,000 pages — and subject to varying interpretations. The chilling effect on banking entities and their employees will mean that the markets will move more slowly, the bid-ask spreads will be wider, and everyone who buys a security will have to pay more when it’s bought and take less when it’s sold than would have been the case before the rule went into effect. This will inevitably raise costs for all companies that issue securities to finance their activities, as well as firms that buy these securities for investment. In the worst case, it will reduce activity in the corporate debt markets and investment in corporate debt.
If you doubt that this will be the effect, there is one fact that confirms it: the rule exempts U.S. government securities from the restrictions of the rule. The Treasury was unwilling to subject its securities to the same restrictions it was placing on the trading corporates.
How does the Volcker rule affect hedging?
Hedging transactions are vital for banking entities and others. When a company uses a hedge it is attempting to reduce the risk of a transaction or a purchase. For example, if a banking entity buys a bond that pays a market-rate of interest, it may simultaneously enter an interest rate swap with another financial institution to protect itself against a decline in interest rates. Is the swap a hedge against the risk on the bond or is it an independent and prohibited proprietary trade? The fact that they were done simultaneously may be some evidence that one was intended to hedge the other, but what if the transactions are separated by a week?
The explanatory material that goes with the Volcker rule is almost 1,000 pages.
Like the market-making example, whether what was done was a permissible transaction or an impermissible proprietary trade will often be a matter of interpretation. The rule requires that hedges “demonstrably” reduce the risk of a specific trade or transaction. That does not mean banks and bank-related entities will stop hedging; they can’t, it would be too risky not to hedge. What will happen is that some transactions may not be done at all because there is no hedge that can without question be shown to demonstrably reduce the risk involved.
The entire set of “London Whale” transactions, where JPMorgan Chase lost over $6 billion, was said by the bank to be a hedge against possible losses on a large portfolio of EU securities. Others claimed that the hedge was a fake, a cover for a proprietary trade that went awry. That points to the fact that hedges themselves can be subject to differing interpretations.
How many banking entities, and how many of their employees, will engage in transactions where they cannot be sure that the hedge they intend to use will demonstrably reduce the risk? The fewer transactions, the less economic activity stimulated by banks and the slower our economy will grow.
Thus, although presented as a rule that will prevent risky bets by insured banks engaged in proprietary trading, the Volcker rule will actually prevent a wide range of bank-related entities from engaging in activities that are no more risky than ordinary lending while chilling the provision of vital services to the financial markets.
Peter J. Wallison is Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.
Image by Dianna Ingram / Bergman Group
Americans were told the rule stops banks from taking risky bets with insured deposits, but it actually bars bank-related entities from valuable activities that pose no threat to deposits and are no more risky than ordinary lending.
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