Too big to fail and the Volcker Rule faces fresh challenges BY TAN SRI LIN SEE-YAN

by **Cals** Mon 13 Jan 2014, 01:59

Published: Saturday January 11, 2014 MYT 12:00:00 AM
Updated: Saturday January 11, 2014 MYT 8:48:54 AM
Too big to fail and the Volcker Rule faces fresh challenges
BY TAN SRI LIN SEE-YAN
READERS still ask: What’s this Volcker Rule we hear so often these days?
I wrote about it in this column: “Whatever Volcker Wants, Volcker Gets?” on Feb 13, 2010 not long after it was first proposed. It took the US Congress close to four years to make it operational. Even so, it remains controversial. I sense there is widespread interest and concern about Too big to fail. So, here goes.
To reduce risks of bank failure, the intention is to prevent banks from gambling with deposits, including small deposits guaranteed by the US federal government (FDIC,Federal Deposit Insurance Corp). The resulting Volcker Rule (named after its proponent, Paul Volcker, former chairman of the Fed, the US Federal Reserve Bank) prohibits “proprietary trading,” that is, making bets with the banks’ money purely for the bank’s own gain rather than to serve its clients.
The US president described it as a “simple and common sense reform to strengthen the financial system.” On Dec 10, 2013, as authorised by the 2010 Dodd-Frank Lawoverhauling the regulation of US financial institutions, five different regulatory agencies (viz. the Fed; OCC, the Office of the Controller of the Currency; FDIC; SEC, the Securities & Exchange Commission; and CFTC, the Commodity Futures Trading Commission) approved the Volcker Rule (VR) to come into force on April 1, 2014.
Ironically, during the long 1,419 days of “sausage making” between conception and birth, VR evolved finally into something far larger and more complicated than originally envisaged (the final version is reported to have 963 pages, with 2,826 footnotes and 1,347 questions reflecting a preamble addressing public comments which will help guide its implementation). The immediate impact is not expected to be too significant since much was already anticipated.
Most big US banks have by now eliminated the most obvious forms of proprietary trading.
Indeed, Wall Street welcomed the certainty that VR is now settled (more or less) to be not as burdensome as originally anticipated. Its effectiveness will depend on the enforcement by banking and market regulators. Banking-focused regulators (the Fed, OCC and FDIC) work to ensure and monitor the safety and soundness of banks and the financial system, while securities regulators (SEC and CFTC) work to protect investors and the broader smooth functioning of financial markets. They all bring different perspectives to their supervisory roles. So, inter-agency co-ordination becomes critical to its effective implementation.
The Volcker Rule (VR)
Although the Dodd-Frank reform legislation was passed in 2010, nearly two-thirds of its many other regulations remains incomplete. So, VR can be regarded as the barometer for the overall strength of the entire law. The main objective, as I see it, is to prohibit regulated large banks from using customers’ money to trade for their own gain. It’s based on Volcker’s simple idea: Don’t let government insured banks gamble in the securities markets.
Taxpayers shouldn’t be forced in the end to stand behind Wall Street’s trading desks. VR needs to be strict enough to prevent banks from making risky bets with their own money. They enjoy the upside on the risks taken, while others (depositors and taxpayers) share the downside. This is aimed at preventing future trading blow-outs on Wall Street. The prohibition draws a bright line, making it clear that banks’ business is about lending, not speculating.
At its core, VR distinguishes between trading that banks are allowed to do – to serve their customers and offset their own risks – from the prohibited trading done solely for their own profit, known in practice as proprietary trading (one of Wall Street’s most lucrative and riskiest activities). In so doing, VR hopes to prevent the build-up of risky positions that nearly sank Wall Street in 2008. But drawing the line has proved contentious.
In the end, VR will allow:
·Banks to assume their traditional role as market-makers: allows buying and selling securities if they can show these deals are made to meet “reasonable expected near-term demands of customers and counterparties.” This concession helps to preserve vital market liquidity. However, it opens up a loophole for banks to mask their proprietary bets as market-making.
·Banks to do proprietary trading in bonds issued by governments (including Treasuries and Municipals) as well as (another concession) bonds issued by foreign governments.
·Banks to place trades meant to offset the risks posed by positions they hold i.e. run-of-the-mill hedging that can also resemble proprietary trading. VR would prefer banks to tie each hedge to the risks of specific positions they have taken. In practice, however, there are few perfect hedges. So, banks resort to “portfolio hedges,” to protect against broad economic risks or unspecified risks (a Black-Swan event). Such hedges are deemed risky proprietary trading (JP Morgan Chase’s “London Whale” trade which cost it more than US$6bil in losses is instructive).
VR now requires banks to identify the risks and then conduct technical “correlation analysis” and “independent testing” to ensure such hedging will “demonstrably reduce the risks.” It also requires banks to conduct “ongoing recalibration of the hedges” to ensure they are not prohibited proprietary trading.
·Banks to require their chief executives to annually attest that they have “in place processes to establish, maintain, enforce, review, test and modify the compliance programme” to show they are not engaged in proprietary trading.
·Banks to require traders engaged in market-making and hedging not to be paid based on the profits made.
·Banks to own not more than 3% of hedge funds and private equity funds.
·Banks to be granted extension of time until July 2015 to comply.
·“Community banks” with less than US$10bil in assets to be exempted.
Too big to fail (Tbtf)
VR was not meant to deal single-handedly with the dangers posed by large banks. Recent reports indicate that VR did come out stronger than Wall Street had expected. That’s good. But is it strong enough to prevent “Too big to fail”? (Tbtf). Lest we forget:JP Morgan Chase (JPMC), the largest US bank, had US$2.4 trillion assets as at June 30, 2013 and debts of US$2.2 trillion: US$1.2 trillion in deposits and US$1 trillion in other debt. The six largest US banks together owe US$8.7 trillion (about the size of China’s GDP). Only a fraction of this represents loans.
Risk-taking is a vital part of free enterprise – it’s necessary for innovation and growth. Healthy enterprises rarely carry debts more than 70% of their assets. Many do with much less. Banks, in contrast, have liabilities exceeding 90% of their assets. JPMC’s debt represents 91% of its assets. European Basel III rules allow banks to borrow up to 97% of their assets; proposed US requirement for the largest bank holding companies is up to 95%. It seems to me that if banks’ equity (i.e. own money) is only 5%, even a small loss of 2%-3% of assets could lead to a bank run! If a number of the big banks are distressed at the same time, systematic failure will ensue.
Conventional wisdom states that banks’ high levels of borrowing are acceptable because banks are good at managing risks and regulators know how to measure them. Both failed to manifest in the 2008 crisis. Yet, we ignore the lessons. Recent scandals point in the same direction: JPMC’s latest US$2.6bil Madoff fraud settlement, coming on the heels of a string of legal penalties totalling US$20bil on the sale of troubled mortgage securities and the “London Whale” trading debacle;HSBC’s US$1.9bil money laundering fine; some of the biggest banks (including Barclays, UBS and Deutsche) more than US$5.8bil fine for manipulating Libor; inappropriate sales of credit-card protection insurance that resulted in a US$2bil settlement by British banks – they all suggest that big banks are also “too big to manage, control and regulate.”
Implicit guarantees of government support encourage banks to over-borrow, take risks and become Tbtf. VR can help to lessen bank risks and Dodd-Frank is supposed to spell an end to bank bailouts. Don’t count on it.
Historically, finance share of the US economy has been about 4%. Today, it’s easily twice that – at its peak, it was 9%. Finance’s role has become pivotal. In the end, banks need to rely much more on equity and much less on borrowing. I understand there is now a serious move to raise the leverage (capital to assets) ratio to at least 6% (3% now under Basel III). Tougher leverage will force the largest US banks to hold more capital.
The eight largest US banks’ ratio averaged 4.3% (against 3.86% among 16 largest overseas banks); together, they hold nearly US$15 trillion in assets (about 90% of US GDP) making US more vulnerable than ever to their miscalculations and mistakes. I share the view of Prof Anat Admati (Stanford University) in The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About it (with Martin Hellwig) and Prof David Skeel (Pennsylvania Law) in The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences that raising equity requirements substantially (as proposed by the US Brown-Vitter Bill) is the single best step for making banking safer and healthier.
Potential loopholes and challenges
VR will usher in change on Wall Street. Indeed, the way Wall Street does business has since changed: the make-up of its trading units, and its personnel policies. In anticipation, the pure proprietary trading units have long gone. The remaining businesses centered on the profit engine, FICC (fixed income, currencies and commodities) have been restructured and retooled given the restrictions imposed by VR.
High performing traders have moved on. Professional managers have moved in. The way the business is managed has also changed. Businesses that remain are likely to see a reduction in the peaks and troughs in FICC’s profitability. They will become more predictable, though less profitable in good years but also less prone to blowing-up a-lá 2008. The changing of the guard is already in motion.
As William Silber, author of Volcker’s biography VOLCKER: The Triumph of Persistence said: “If a firm like Goldman Sachs, which is now a bank, can’t speculate, then the pendulum will swing.” Indeed, the pendulum has been in motion for a while. VR will help improve the compensation culture of Wall Street, long based on profit-sharing with traders. It now prescribes how traders are paid – they can only receive a discretionary bonus. No more rewards from “prohibited proprietary trading.”
VR draws a line between everyday banking and Wall Street wheeling-dealing. Critics say VR doesn’t go far enough. On its part, Wall Street is expected to scour for loopholes to challenge it in court; they regard VR as too severe, constricting the flow of capital so badly needed to oil the economy. Supporters want VR to prevent the build-up of the kinds of risky positions that nearly sank Wall Street in 2008 and led to the recent US$6.2bil London Whale trading loss at JPMC, resulting from a sprawling speculative position under the guise of hedging that spun out of control.
Also, critics worry whether VR is strict enough to force banks to stockpile securities only for customers and not mask their proprietary bets as market-making or hedging. This appears to be one of the most challenging rules to get done in a balanced way.
Regulators say they have worked in good faith along this path. In the end, the Treasury Secretary sums it up best: “regulators should err on the side of doing a little more, and then correct it if you’ve gone too far.”
Nevertheless, unpleasant surprises have since emerged: (i) the American Bankers Association has raised concern that VR unintentionally bars small “community banks” from investing in trust-preferred CDOs (collateralised debt obligations) that currently form a large part of their capital; and (ii) the US Chamber of Commerce has urged a rethink on VR to avoid “unintended consequences,” including “impeding the ability and increasing the cost of non-financial businesses to raise capital and manage risk” and “places the American economy at a competitive disadvantage.”
What then, are we to do?
The starting point of VR is a good one – with a guarantee on small deposits, it makes good sense not to allow banks to gamble with their deposits. The ultimate aim is to stop taxpayers from having to bail out feckless financiers once again. VR is good, even though imperfect – a good start towards getting banks back to being banks. VR has lots of potential grey areas that banks may be able to exploit.
Nevertheless, many believe that inventories of stocks, bonds and derivatives are likely to get leaner, reducing the probability of them becoming a significant source of bank losses. Indications are that Wall Street’s inventories have since shrunk considerably. But VR may not be tough enough over time to stop banks from adding on once again excessive amounts of risky assets under the guise of market-making or hedging.
VR provides considerable leeway. Risks remain. Five years after the Lehman Brothers bankruptcy, we are no safer. Tbtf continues. The lessons of the crisis have slipped by. Fed chairman has acknowledged that the Tbtf problem has not been solved.
VR will help limit risks but until banks are pushed to rely much more on money from the owners and shareholders to finance their loans and investments,
Tbtf will continue to haunt us, VR or no VR. That’s today’s reality.

Former banker, Tan Sri Lin See-Yan is a Harvard educated economist and a British chartered scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: [You must be registered and logged in to see this link.]