Banks thirst for watered-down Volcker rule

Critics of the Obama administration’s planned rule to halt deposit-taking institutions’ proprietary trading activities argue that its aim was to score political points rather than present a practical solution for avoiding future financial crises.
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Critics of the Obama administration’s planned rule to halt deposit-taking institutions’ proprietary trading activities argue that its aim was to score political points rather than present a practical solution for avoiding future financial crises.

However, the White House’s so far staunch defence of former Federal Reserve chairman and senior Obama economic advisor Paul Volcker’s eponymous rule would make a retreat unwise and unlikely. In addition, despite criticism of the Volcker rule’s lack of detail, its core principle – that banks should not gamble with clients’ deposits – is tough to dispute. As such, many feel that some form of proprietary restriction, both within and outside the US, is inevitable. “The governments will pass something – they have made too much of a noise about it not to,” said one broker.

Nevertheless, it is by no means assured that the US’s current proposal will be the blueprint for reducing the risks banks take in the securities markets. Many are predicting a watered down version – not only because of the banks’ own powerful lobby, but also due to the lukewarm response of other jurisdictions’ regulators, policymakers and advisors. Paul Myners, financial services secretary at the UK Treasury, and David Wright, deputy director-general at the European Commission’s internal market division, are among those that have proclaimed themselves less than enamoured with the Volcker rule. The US would prefer not to act alone for fear of driving banks to rival market centres.

“It is not as if Volcker’s proposals are necessarily agreed in other jurisdictions,” says Bob McDowall, research director, Europe, at research and consulting firm TowerGroup. “Whatever comes out is likely to be watered down by jurisdictional considerations.”

If regulators have their heart set on a ban, they will need a razor-sharp definition of which practices can and cannot be undertaken, which in itself could narrow the impact of any restrictions. For example, if regulators merely sought to prevent banks from running a dedicated proprietary desk, this would allow banks to continue their client facilitation activities – and any trading done on the back of positions assumed while undertaking them – unfettered.

However, many critics have been trying to steer the US away from an outright ban, instead favouring certain limits. One option could be to ringfence large institutions’ client deposits, making it impossible to use them for funding prop trading activities.

Another method would be to try and limit the amount of capital or leverage that a bank could apply to its prop book, or setting certain credit and risk limits for the positions assumed. “A regulation might stipulate that a bank has to put in place a policy that demonstrates they have an airtight procedure implemented around proprietary trades,” suggests Simmy Grewal, analyst in the institutional securities and investments practice at research and consulting firm Aite Group. “This policy may incorporate various risk limits and viable solutions for closing a trade if these limits are breached.”

The UK’s preferred approach to limiting prop trading appears to be an imposition of harsher capital and liquidity requirements, as suggested by the Turner Review – a recommendation for post-crisis banking regulation published by Lord Adair Turner, chairman of the UK’s Financial Services Authority – published in March 2009.

However, regulators’ best efforts to restrict prop trading activity may bear little fruit. Banks have proven themselves adept at sidestepping regulatory obstacles in the past, and many feel there is every reason to believe this will be the case with prop trading, particularly given the many calls for the Volcker rule to be tempered and clarified.

“Market-making and trading are tied fairly closely together, so there will be lots of exemptions,” says one broker. “I suspect very smart people will figure out and understand how to exploit those exemptions to maintain many of the same activities.”

For example, a ban on dedicated prop trading desks could see more prop trading shifted to the main desk and made to look like client facilitation.

Equally, some banks may choose to shed their deposit-taking elements to escape regulators’ clutches. This may be particularly easy for those that have only acquired the status recently. “It wouldn’t heavily impair Goldman Sachs and Morgan Stanley if they lost their deposit-taking operations because it is not a pivotal part of their business,” says Grewal. “If a regulation came into play that wouldn’t allow them to prop trade if they took deposits, I’m sure they would favour prop trading.”

Other US institutions with a foot firmly in both camps, however, will take a keen interest in the rule’s progress into law. The rule is intended to augment the existing financial reform package currently moving through Congress. The House of Representatives passed its version of legislation based on the reform plan. The administration is thought to be working on a draft legislative proposal for the Volcker rule for submission to Congress.

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