The Volcker Rule: How Complexity Kills Good Ideas

“We supported former Federal Reserve Chairman Paul Volcker’s simple idea: Don’t let federally insured banks gamble in the securities markets. Taxpayers shouldn’t be forced to stand behind Wall Street trading desks. What we can’t support is the “Volcker Rule” that was first distorted in the 2010 Dodd-Frank law and has now been grinded and twisted into 71 pages of text plus 882 more pages of explanation after three years of agency sausage-making.” ~ December 11, 2013 Wall Street Journal Opinion: ‘The Volcker Ambiguity’

Introduction. Just like the Dodd-Frank Act (at 2,200 pages), upon enactment of the Volcker Rule (at nearly 1,000)[1], there will be those hailing this as a new era of regulation, preventing those nasty banks from making risky bets and obscene profits; we will be constantly reminded that this new rule is necessary to prevent the Big Banks from ever again causing a meltdown in the credit and housing markets.    

The problem with this narrative is that it isn’t true; it is based upon a false predicate – it was not the absence of regulation that caused the financial crisis. It was the absence of enforcement. Yes, the Big Banks played fast and loose with their own underwriting, making loans to folks who should never have received them; yes, the Big Banks sold those loans to Fannie, Freddie, and into the private label secondary market, falsely touting them as solid gold, when they were Fool’s Gold; and yes, by 3Q 2008, the capital markets collapsed, which, along with the hyper-inflated real estate markets, resulted in a world-wide recession. This all occurred under the not-so-watchful eyes of the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of Comptroller of Currency, the Department of Treasury, and other faux regulators employed by the American Taxpayer to protect the American Taxpayer.

It is a mistake to believe that any amount of complex federal rulemaking can ever serve an effective deterrent against economic avarice.  As water finds its path of least resistance, so does greed: If one channel is blocked, another is found. The Volcker Rule is not immune from this principle.

Before diving into the Rule, let’s look at how the Big Banks make Big Money. Obviously, one is by making loans, which needs no explanation. But let’s talk about the Big Banks acting as “Investment Houses.”  How do they make the “real” money that results in the huge Wall Street bonuses we hear about? 

1. Proprietary Trading, or “Prop” Trading.  Quite simply, this is when the bank makes bets with its own money and for its own account – as opposed its customers’ accounts.  The traders “…are generally “walled off” from the rest of the bank, and generate only a portion of total trading revenues.” [Financial Times Lexicon.] 

2. Market Making.  In order to sell bonds, Wall Street banks must first own them. Ergo, they must buy them from another dealer.  According to Market Watch online:

Unlike the stock market where there are central exchanges, the bond market is a dealer-to-dealer market, and to do any kind of market making, any dealer has to put the assets onto their books. The dealer has to own them for at least a few seconds before selling them to someone else…. 

Thus, if a bank wants to serve its customers, it will use its own capital to make a market in a certain instrument, offering itself as a buyer to a client that wants to sell, or a seller to a client that wants to buy. If the bank has the product available, it can generally determine the sell price and avoid much risk. It is only when this takes the form of an arbitrage as prices are moving quickly, that risk enters the equation.

3. Hedging.  This is the process of offsetting the risk of loss on an existing bet by taking an offsetting bet. Hedging reduces the risk of rapid market swings that could create or exacerbate a loss on a position the bank has taken.  Banks would say they need to hedge portfolio risk and that it is a prudent business tool.  This is true. But when large risky positions are taken [as in the London Whale fiasco], they start to look more like proprietary trading than true risk management.

The Volcker Rule.   The original intent behind the Volcker Rule was to prohibit FDIC insured banks from making risky bets that could bring them down, and ultimately cost their customers or the American Taxpayer money.  In other words, the purpose of the Volcker Rule was to rein in proprietary trading.

Since it was proposed by former Fed Chair Paul Volcker, it bore his name, although I’m not sure he would claim paternity today, since the “Rule” bears little resemblance to what was originally intended.  And since I was not a close follower of the administrative process, I don’t know how many cooks were involved in making the broth that is now being served up.  It appears they were primarily from the banking and finance industry.  According to former Delaware Senator Ted Kaufman writing in Forbes:

A study by Duke Law Professor Kim Krawiec demonstrated how lopsided the lobbying on the Volcker Rule was. She found that, between July 26, 2010 and July 7, 2011, 93.6 percent of the meetings with commissioners and staff of the five regulators charged with writing the rule were with financial institutions, law firms representing financial institutions, or financial institution trade associations, lobbyists, or policy advisors. Only 3.2 percent represented labor or public interest groups; another 3.2 percent came from congressional staff members.

Sen. Kaufman, in the Forbes article, did not mince words in describing the current iteration of the Volcker Rule:

After nearly four years and countless hours spent negotiating and writing the rule, the five agencies involved have produced one of the great pieces of Swiss cheese in regulatory history—so riddled with exceptions, contradictions, and foggy language that the major celebrants will be the Wall Street lawyers who have been given the Christmas gift of their dreams.

 So if 93.6% of the chefs were from banking and finance [and, of course, with their lawyers and lobbyists in tow], why should we be surprised with the resulting brew? Rather than pounding the table and throwing tantrums about how unfair it all was, the banking and finance guys circled the wagons, bucked up, and decided to inundate the overworked regulators by demanding exceptions, carve-outs, loopholes, escape hatches, and other tricks for gaming the system.[2] So the delay discussed in the Davis Polk scorecard at Footnote 1, should come as no surprise.

The $64,000 Question. One has to wonder whether the prohibitions on proprietary trading as intended by the Volcker Rule would have ever passed, except for one thing – J.P. Morgan’s London Whale; a gift handed to the regulators in April and May of 2012, when the London branch of its Chief Investment Office lost $6.2 billion in what looked suspiciously like prop trading. It was an “I told you so!” moment, and stifled the banking industry’s effort to kill the Volcker Rule. Until then, the regulators had no such cautionary tale to give as a reason for the law.  The London Whale was a cause célèbre for the regulatory set in Washington; meanwhile, Jamie Dimon, the CEO for JPM, and one of the Rule’s biggest detractors, ate crow. 

The Disconnect.  Wait! The Volcker Rule was a part of Dodd Frank, when it was enacted in July, 2010.  The London Whale fiasco didn’t occur until nearly two years later.  Does this mean that the Volcker Rule was proposed before the London Whale scandal occurred?  That at the time the Rule was proposed, Bruno Iksil was just another anonymous trader in J.P. Morgan’s London trading desk?  That Paul had never met Bruno?  Yes, yes, and yes! So the London Whale wasn’t the fish that swallowed Manhattan in 3Q 2008.  Risky prop trades did not cause the Wall Street financial meltdown.  So riddle me this, Batman: What were the risky prop trades occurred Paul Volcker was trying to prevent?  Surely there must have been some trading disasters that caused the credit markets to crumble? What were they? Answer: It was not prop trading that caused the financial crisis in 2008-2009.[3]

So What Caused The 2008 Financial Crisis?  The primary culprit behind the 2008 crumbling credit markets was repo transaction conducted in the shadow banking system. The term “repo” stands for “repurchase agreement,” as where one entity transfers certain security for quick cash and a commitment to repurchase it back. The repo market in 2008 was a large source of overnight intra-bank funding, and worked so long as everyone was comfortable with everyone else’s liquidity.  But since the shadow banking system is highly opaque and not regulated, the big banks and investment houses could only surmise about their counterparties’ solvency.  Here’s how it has been described by the Financial Times:

These practices have their uses, both for those who engage in them and more broadly by making securities more liquid (because they are easier to turn into money-spinners). This, at least in theory, should lower the yields that securities issuers have to pay for funds.

But they can also greatly [destabilize] financial markets. Repo transactions turned into a significant source of short-term funding for banks before the crisis. This created under-appreciated risks of a run on banks in the form of a sudden stop in repo financing – rather than the classic threat of deposit flight – which eluded regulatory attention. That was because the repo market involves non-bank financial institutions – now seen as a “shadow banking system” since it imitates banks’ combination of short-term borrowing and long-term lending. The most dramatic moment of the crisis – Lehman Brothers’ bankruptcy – was caused in this way.

Why did Lehman fail? Because it depended too heavily on the repo market for its daily operations, and without that funding, could not survive.  Why did Lehman’s funding dry up?  Because the rest of the financial marketplace suspected it was overinvested in subprime mortgage backed securities which were beginning to falter.  Lehman was perceived as a zombie – more dead than alive – and no one would do repo transactions with a zombie holding (now) illiquid and depreciating securities.

The Banking Industry After The Volcker Rule.  So what will be the long term effect of the Volcker Rule? My prognostications:

• Changes of form, not substance. Banks will go through the motions of compliance, thus avoiding the appearance of “flaunting” the rules;
• Securities lawyers who bill on an hourly basis will be the beneficiaries;
• Hedge funds and private equity funds will  benefit, since banks are limited in their ownership and will spin some or all of them off;
• Big Banks will shift their focus from prop trades to market making or disguise their prop trading as hedging;
• Since the Rule still permits certain hedging, the line between that activity and prop trading will blur.  We already know this from the London Whale, which was first characterized by JPM as a hedge gone awry;
• The Volcker Rule will be tied up in litigation and other battles which will have the desired effect of declawing the regulators in close cases;
• Besides, there are several delayed compliance periods.  According to Ellen R. Marshall, partner at Manatt, Phelps, & Phillips, LLP, “the Volcker Rules is Final], Lexology website here:

Although the effective date of the regulation is April 1, 2014, there are several delayed compliance periods.  The Federal Reserve has extended the conformance period until July 21, 2015. Also, banking entities of different sizes will have until as late as December 31, 2016, to commence reporting regarding compliance. Larger banks must comply sooner, with the earliest required reporting date–for banking entities of $50 billion or more in consolidated trading assets and liabilities–coming on June 30, 2014.

The new Volcker Rule will not result in Big Banks losing money – they never do. According the Huffington Post:

The four biggest U.S. banks — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — today have about $7.8 trillion in assets, or about 47 percent of U.S. gross domestic product, up from $6.4 trillion, or 43 percent of GDP, at the time of the crisis in 2008. The six biggest banks, a group that now includes Goldman Sachs and Morgan Stanley, now have $9.6 trillion in assets, or nearly 58 percent of GDP.

So fear not; life for the Big Banks will go on, long after Paul Volcker has smoked his last stogie. Banks and regulators will continue to play their cat and mouse games; banks will continue to contribute to Presidential coffers, such as Mr. Obama’s, who takes their money while derisively calling them “Fat Cats;” and the Brer Rabbit Banks will continue to plead with the Brer Fox Bureaucrats, not to throw them into the Briar Patch of federal regulation.  And so it goes, and so it goes….