Has banking’s world order changed? U.S. regulators’ approval of the final version of the Volcker rule, a restriction on banks’ proprietary trading, is being billed as the toughest piece of U.S. financial-markets regulation to come out of the aftermath of the 2008 global financial crisis. Named after Paul Volcker, the former Federal Reserve chairman, it aims to ban banks from making the speculative bets that Volcker believes helped cause the crisis.
On paper — and there is a lot of paper; the rule runs for more than three score pages and ten — it lives up to its billing; in practice, it will depend on what loopholes are to be found in those densely packed pages, and how the five regulatory agencies they affect interpret and implement the rule. It goes into effect on April 1 next year, although the compliance date will be delayed to July 21, 2015, and large banks will be required from June 2014 to show they are working to comply with the rule.
The big banks spent four years and many millions of lobbying dollars since the passage of the Dodd-Frank financial reform act in 2010 trying to water down the implementation of its Section 619, where the Volcker rule is codified and which covers “prohibitions and restrictions on [bank’s] proprietary trading and certain interests in, and relationships with, hedge funds and covered funds.” They will still say the sky is falling now the final version is approved. The fact that shares in Morgan Stanley and Goldman Sachs, the two big Wall Street banks most reliant on proprietary trading, rose after the Volcker rule’s approval gainsays the point. The big Wall Street banks have anyway mostly wound down their proprietary trading desks.
In short, banks will still be able to buy and sell bonds and other financial instruments as long as they can show regulators that these activities are aimed at meeting the “reasonably expected near-term demands of clients, customers or counterparties.” They have also got a broad exemption for trading sovereign debt. Is there enough wiggle room there for trading desks to use risk hedges to hide proprietary trading? It is probably not beyond the wit of Wall Street traders to find it if there is.
In the end the effectiveness of the Volcker rule will probably come down more a matter of regulatory judgement than rule-making per se. The $6 billion of derivatives trading losses incurred last year by JPMorgan in the ‘London Whale’ debacle is a case in point. The bank’s regulators had scant idea about how the bank’s enormous synthetic credit portfolio functioned. In light of that, the Volcker rule makers have required a deluge of information to be provided to regulators by a bank explaining the specific risks its traders are taking. But where does a hedge stop and a proprietary trade start? As Volcker himself has said, proprietary trading is like pornography; you know it when you see it. It will be a regulator’s call.
As has been frequently noted, the culture of risk-taking in Wall Street has remained immutable since 2008. The Volcker rule contains a provision that that trading-desk compensation must not reward either proprietary trading or “excessive or imprudent risk-trading.” Again, this is language broad enough to drive an eight-figure annual bonus through, but if the rule leads to banks rewarding hedge-builders for long-term success in keeping positions balanced, rather than racking up short-term profits, then that may be the biggest change of all it will cause to banking’s world order.