What's At Stake With The Volcker Rule?

The Republican’s Financial Choice Act has sparked a wave of debates on the Volcker Rule. There are also many questions on what President Trump refers to as the “Modern-Day Glass Steagall Act”. Treasury Department was asked to review whether existing laws and regulations follow President Trump identified “core principles” of his administration. Let’s see what are at stake regarding the Volcker Rule.

(1) Synching with the “America First” Principle

A key exemption to the Volcker rule specifically allows banks to continue to engage in proprietary trading in U.S. government, agency, state, and municipal obligations. This privilege is definitely synching with President Trump’s“America First” principle. Americans should be pleased because this favorable policy has made the U.S. government debt less depending on foreign countries, such as China.

(2) Rejuvenating Liquidity in the Markets

Regulators never rule out banks holding of securities inventory over 60 days. Besides, banks are allowed to have up to 3% sponsorship (investment limit) of a hedge fund (HF) or a private equity (PE). Through an arm-length relationship, HFs / PEs can engage in risky bet of infrequent trade securities, while their sponsoring bank(s) earn a carried interest without violating the law. Widening backdoor is relatively less complicated than “reinterpreting” what is proprietary trading. CGFS-52 already provided a comprehensive definition of proprietary trading versus market-making, there is no point in reinventing the wheel.

(3) Divergence of International Financial Regulations

Regulators around the world are looking to achieve the same goal – “taxpayer-funded bailouts should be prevented”.  Yet, each country has some variations in implementation (e.g. Vickers / Liikanen). “Foreign exclusion” requirements of Volcker are too harsh, and foreign banks cannot afford to lose the U.S. market. They are scrutinized twice and this meets President Trump’s goal of “enabling American companies to be competitive with foreign firms."

In order not to upset the American allies, the Volcker rule permits proprietary trading in the obligations of a foreign sovereign or its political subdivisions under “special circumstances”. This “special circumstances” clause under Volcker gives the U.S. adequate leeway for “international financial regulatory negotiations”.

(4) Mixed bag of Effectiveness and Efficiency

The U.S. Federal Reserve has provided a regulatory relief/ 2022 extension for bank ownership of covered funds in order to allow for a stable run-off. This “extension”policy is efficient and effective from the perspective of U.S. financial stocks trading at 30 plus percent premium to their book value (see this for a comparison with that Chinese banks that trade at a discount between 15-25%).

The most ineffective and inefficient part of the Volcker Rule resides with the metrics. Though regulators may use the “guilty until proven otherwise” clause to bring charges against banks, but they seems not familiar with that power or hesitated because their prescribed metrics aren’t effective to prove a bank’s trade activities may be in compliance or violations. Changing up these metrics won’t be helpful because no static metric would serve as proper “qualifier” of the various Volcker exemptions.

(5) Appropriate Reliefs and Tailored Incentives

I disagree on making the rule only apply to the top 10 or 12 G-SIBs. A healthy market needs more diversity of players. The more stringent the rule, the more it’ll push the industry into further consolidation. Smaller banks cannot justify the heightened regulatory compliance costs on their own but to seek mergers and acquisitions. Therefore, one should consider appropriate incentives to motivate the medium and small players to improve their risk management capabilities. Consequently, they’ll become more effective to compete in the market and increase diversity (i.e. choice). This indeed may be the most effective way to curb TBTF (too big to fail).

(6) Avoid Policy Mistakes and Modernize the Rules

The modern day financial industry biggest supervisory challenges arise from things happening too fast and changing so dynamically. Static metric reports are neither effective to curb misbehaviors. Attempts to change up these metrics bound to fail because it is majoring in the minors. To avoid policy mistakes, modern supervisory policy must use engineering approach to address financial engineering problems. Below I suggest a 3 prong approach:

(a) Remove 79 FR 5592 – Footnote 711 of Volcker, so it’ll synchronize with the SEC’s consolidated audit trail project for a transaction-by-transaction scrutiny on abusive use of securities inventory (see this).

(b) Monitor market risk versus credit risk exposures. Banks shouldn’t undertake excessive credit risk to make up for revenue loss caused by Volcker’s mandate to reduce market risk exposure.

(c) Enforce appropriate behaviors of market makers. It is uncertain that non-bank HFTs will stand ready to provide market liquidity in both good and bad times. Shadow banking system can be a threat to financial stability.

(7) Restore Accountability with Federal Agencies

The latest speech by Vice-Chair Hoenig of FDIC is the most backward thinking contrary to the advancement of modern regulatory supervision. The way he passes the buck to the SEC and CFTC signified that silo issues existed within federal agencies. There lack cooperative efforts to deal with modern days’ financial engineering problems. Regulators should foster the industry’s advancement in risk management practices (e.g. implement preventive risk control in real-time, active surveillance), rather than blindly following Basel to continue heightening of capital (which is a two-edged sword).

The Volcker rule has in-large synchronized with President Trump’s core principles. I encourage Treasury Secretary Mnuchin to consider my three-pronged >approach highlighted in point (6) that will balance the right industry developments with fulfillment of 21^st Century Glass-Steagall’s objectives. Click here to read the full whitepaper and see elaborated details of how the many stakes on Volcker may severely affect the broader economy. 

Kelvin To is the founder and president of Data Boiler Technologies.