Volck(er) Wisdom?

How long can it take to write a rule? With the ‘Volcker Rule,’ U.S. regulators may be gunning for a world record.

By Echelon.

Published on May 02, 2013 with No Comments


Following the U.S. financial meltdown in 2008 with its ensuing recession and Wall Street bailouts, Congress enacted the ‘Dodd-Frank’ Act in 2010, aiming to forestall future crises. The most comprehensive U.S. financial reform since the Great Depression, Dodd-Frank addresses the roots of the 2008 crisis in massive trading of housing sector financial instruments. It requires that sellers of mortgage-backed securities (MBSs) assess and disclose risks; curtails issuance of high-interest mortgages to those who cannot afford them; and imposes professional standards on credit rating agencies, who before the crisis cheerfully signalled thumbs up on MBSs backed by risky ‘subprime’ mortgages, just as defaults began piling up.

Dodd-Frank pursues reform on other fronts as well. It requires that ‘shadow’ players like hedge and private equity funds disclose their risk profiles. It establishes a council to issue and enforce rules protecting consumers in credit transactions. And it establishes the Financial Stability Oversight Council with broad powers to prevent financial houses from getting into perilous ‘too big to fail’ scenarios endangering the credit system. The Council can impose increasingly tight rules on capital, leverage, liquidity, and risk management for the largest and most complex houses, those designated as ‘systematically important financial institutions.’ Momentous though all this may be, Dodd-Frank’s most pivotal reform may be the Volcker Rule, named for its leading advocate, the Reagan-era Federal Reserve chairman. The Rule bans banks from ‘proprietary trading’: buying and selling securities for their own profit rather than on behalf of clients. Buying and selling securities is risky business, of course, and the biggest rewards come from the biggest risks. Wall Street magnifies risk in two ways. First, it hands out whopping bonuses to in-house traders who score big hits. Why not play a hunch that could make you a multimillionaire when the worst downside is getting fired, then hired by someone else at a normal banking salary? Second, the big houses know that if they get too deep in bad bets, Uncle Sam will bail them out so as to forestall financial sector meltdown: welfare for Wall Street.
Worse, bank equity is only a fraction of what Wall Street bets with. Also on the table are depositor funds and loans from outside creditors. The first puts ordinary bank accounts in jeopardy while the second transmits risk through the interlocking financial sector. Like all gambling, proprietary trading delivers no aggregate benefit: every gain means someone else’s equivalent loss. The point is to stop banks from gambling, especially with other people’s money. Volcker Rule proponents contend that it will ensure a more stable and secure credit system.
Besides banks, who could quarrel with Volcker? One difficulty is that the Rule could threaten beneficial activity that looks like proprietary trading but isn’t: banks buying and selling instruments for purposes other than securing a profit. Accordingly, Dodd-Frank itemizes ‘Permitted Activities’ – two key ones are market making and hedging – not covered by the ban on proprietary trading.Fine, but how can a regulator or prosecutor tell whether a given trade or set of trades is proprietary or not? How can a bank be sure that permissible trades won’t be wrongly punished? Dodd-Frank directs both bank and securities agencies to draft regulations delineating permissible from impermissible trades. When adopted, these regulations will be the real Volcker Rule. This drafting task was supposed to be done within a year but is still unfinished nearly three years after Dodd-Frank’s enactment. The agencies have reviewed some 18,000 comment letters from interested parties, some of them hundreds of pages long. One working draft of the regulations runs to 300 pages. Bank and securities regulators have failed to find common ground on some key issues. Banks protest that the Rule’s sheer complexity will gum up their operations, while reformers worry that the final product will be a Swiss cheese of loopholes.
As Dodd-Frank recognizes, both market making and hedging add value to the credit system.
To grasp the importance of market making, consider corporate bonds. It’s much easier and cheaper for corporations to borrow if lenders know that they can re-sell their bonds if they need cash in a hurry. But corporate bonds are as different from each other as are the thousands of firms that issue them. Unlike equity shares, which can easily be sold in chunks of any size, few corporate bonds enjoy a fungible mass market where a seller can find a buyer on short notice. Instead, the market relies on banks, which buy now and hold to sell later when a buyer can be located. A market that would otherwise be illiquid becomes liquid.
But wait, what if a bank sells bonds for more than it paid? Having made a profit, Mister Bank, you are now under arrest for proprietary trading! In its defence, the bank can try to prove that its inventory had high turnover or did not exceed ‘reasonably expected near-term customer demands.’ The problem with such defences is their inherent vagueness. If banks reduce exposure by curtailing their market making, bond resale markets will lose liquidity and corporate borrowing costs will go up.
‘Hedging’ means buying one instrument to offset the risk of owning another. It is a kind of insurance. Say you’re a market maker holding a particular corporate bond and you’re worried that its value will drop because poor economic conditions in that sector have raised risks that the corporation will default on its bonds. You don’t want to sell the bond at its current price, however, because you also see some potential for it to go up. You might hedge against an unacceptable price drop by purchasing a ‘put’ contract: an option to sell the bond to a given buyer at a price determined now. If the bond price sinks below the ‘put’ price, you sell, having paid the buyer to accept the risk of further price decline.
Hedges and hedging strategies come in all shapes and sizes. Portfolios can easily become a maze of hedges (pun intended), where proprietary trading can hide. Returning to our example, as the price on the bond you’re holding sinks toward the ‘put’ price, the value of the ‘put’ you own may be rising inversely. This inverse price rise is a second hedge dimension of the ‘put.’ Suppose you conclude that your bond’s price decline has levelled off, but you find another holder of bonds in the same series who is more worried than you are. You manage to sell your ‘put’ to him for more than you paid. Have you been engaged in an evolving hedge strategy or in proprietary trading?
Regulators must try to light up the shady boundaries between proprietary and permissible trading, while balancing the risks of under-enforcement against those of chilling permissible and worthwhile activity. The task is complicated by the sheer number and intricacy of actual and potential financial instruments, with their various peculiarities and economic impacts: equities, commodities, bonds, derivatives and more, in all their bewildering efflorescence, with differing liquidity profiles, hedge usages, holding period strategies and so on. Many instruments trade in small volumes, at low turnover, with no central exchanges.
Enforcement practicalities must be considered along with pure policy considerations. It will generally be impossible to identify proprietary trading based on particular deals. Instead, patterns of trading must be studied by means of various ‘metrics’ with their own comparative advantages and disadvantages. Will all this be workable and worth it? Reformers fear that the Volcker Rule as implemented will prove unequal to the tasks of shutting down proprietary trading and stabilizing financial markets. Some propose restoration of the Glass-Steagall Act requiring strict separation between ‘commercial’ banks—those that accept deposits and use them to issue loans to firms and households—and ‘investment’ banks, which trade in financial instruments and earn fees for structuring the issuance of bonds and equities. Under Glass-Steagall, investment banks could not accept deposits but could borrow from outside lenders. Commercial banks could not deal in financial instruments.
Between its passage in 1933 and its repeal in 1999, Glass-Steagall safeguarded depositors against risky financial dealings, while also protecting the U.S. Treasury, which guarantees deposits against bank failures. Critics castigated Glass-Steagall, however, for stifling innovation and wealth creation in the finance sector. Its repeal had support from both parties. Restoration of Glass-Steagall might be wise and, post-2008, might draw a lot of support, but it might not be the critical priority right now and it would certainly not solve all problems. Though it would protect depositors, it could leave leeway aplenty for risky mischief by ‘too big to fail’ investment banks.
From another corner comes a proposal to regulate finance instruments themselves, not just banks and their activities. Professors Posner and Weyl argue that certain kinds of instruments inherently promote gambling, delivering little or no real economic value, and should be illegal because gambling destabilizes both players and markets. They propose a Financial Products Agency to review and approve novel instruments before they can be offered for sale. Approval would depend on whether an instrument’s real economic value outweighs its gambling value, just as the Food and Drug Administration approves a pharmaceutical only if its therapeutic benefit exceeds its dangers. Because such review might go far toward ensuring financial stability, its feasibility should be explored.
> A graduate of Harvard Law School, Mark Hager lives with his family in Pelawatte. He consults on complex legal and writing challenges.


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