Volcker Rule Carries Lots of Unintended Consequences, Warn Critics

As federal regulators move toward adopting a final version of their 298-page proposed rule to restrict proprietary trading by banks, plenty of critics are warning about the unintended consequences to the financial markets that they say the Volcker Rule will inflict.

In comment letters to the Securities and Exchange Commission and other federal agencies, executives at financial firms and their representatives have argued that the Volcker Rule will send harmful shock waves through the financial sector.

“We are concerned that the approach taken by the financial regulators … poses significant impediments to our ability to effectively and efficiently manage our client portfolios,” wrote Amy Koch, director of fixed income trading at Standish Mellon Asset Management Co. “We understand that neither we nor our clients are the direct targets of the proposed changes, but we will both be impacted inadvertently by their detrimental effects.”

While the flow of comment letters to the SEC has been steady, it hasn't been the flood that some expected. Many of the early comments insisted that the banking community needed more time to evaluate the proposed rule. In response, the SEC extended the deadline for comments from Jan. 13 to Feb. 13. “The bulk of the comments from industry and market participants will come in closer to the end of the deadline. People are trying to think out all the issues,” says Edward Johnsen, a partner at law firm Winston & Strawn.

At the heart of the debate is the ambiguity many see in the way that regulators have proposed to distinguish between market-making activities and proprietary trading.

“The problem is regulators are focusing too hard to remove any aspects of proprietary trading from the market. They are trying to search and destroy proprietary trading at a high level. That's why the proposed rule is written in such a broad manner,” says Bob Colby, partner at law firm Davis Polk. He says the broad application of the rule could chill some markets where proprietary trading boosts liquidity.

Hal Scott, director of the International Financial Systems program at Harvard Law School, says that although market-making is clearly permissible under the rule, market participants worry about how regulators distinguish between the two activities. “This is how regulators think: ‘The banks are trying to pull a fast one on us. We prohibited proprietary trading but they are doing it under the name of market-making,'” he says.

He says the rule could cause banks to pull back from the market-making activities. “It extensively regulates market-making and will cause the dealer banks to pull back from the activities they are doing, for fear that it will be called disguised proprietary trading. That's the problem,” Scott says.

Higher Rates?

Some corporate debt issuers worry that the ban on proprietary trading could result in higher borrowing costs. John Newman, director of investment for Dominion Resources, one of the top 10 participants of the country's $178 billion corporate commercial paper market, says up to 14 percent of investors in Dominion's portfolios are banks. “If the Volcker Rule prohibits the banks from proprietary trading in the commercial paper market, 14 percent of our investors walk. If you take 14 percent of my investor banks away, what is going to happen to my rate?” he said during a panel discussion hosted by the U.S. Chamber of Commerce earlier this month.

Darrell Duffie, a finance professor at Stanford University, agrees that the rule will lead to higher borrowing costs for consumers, businesses, foreign governments, and others. In his report “Market Making Under the Proposed Volcker Rule,” he says the proposed implementation of the rule would lead to a significant loss of market-making capacity of banks, and banks handle the bulk of market making. With less-liquid markets, investors will demand higher yields on securities issued by companies to make up for that liquidity risk, he says.

“The problem is regulators are focusing too hard to remove any aspects of proprietary trading from the market. They are trying to search and destroy proprietary trading at a high level. That is why the proposed rule is written in such a broad manner.”

—Bob Colby,

Partner,

Davis Polk

Another part of the Volcker Rule governs banks' involvement in hedge and private equity funds. The rule attempts to restrict banks from investing, sponsoring, or making transactions with these funds for their own accounts, except for a few proposed exemptions. The exemptions, which are complex and have also generated considerable controversy, cover transactions for the purposes of asset management, hedging, foreign activity by foreign banks, loan securitizations, investment in a small-business investment company, and various other transactions.

Banks' ownership of these funds is capped at 3 percent of their total assets, calculated by combining equity capital and retained earnings. Each fund will be governed by different permissible activities' guidelines, which banks must satisfy prior to sponsoring the different types of funds.

Critics also take issue with the cost and difficulties they expect to come with complying with the rules, since it brings a host of new compliance and disclosure requirements. Banks with more than $1 billion in trading assets and liabilities and that are engaged in permitted market-making activities, for example, will be required to collect data and provide regulators with quantitative metrics for supervision purposes—and those metrics have yet to be identified.

There is also a compliance program requirement on banks engaged in permitted trading activities. The minimum requirement is for banks to at least have internal written policies and procedures to describe, monitor, and ensure compliance with the statute. Other requirements include an internal control function and independent testing of program effectiveness, training, and recordkeeping.

Support for Volcker

Not all of the feedback on the Volcker Rule has been negative. Amid complaints about its many restrictions and requirements, some commentators say the rule, even in its current complex form, will bring some benefits to the industry and market participants.

IIB CONCERNS

The following excerpt is from Mark Standish's testimony before the U.S. House of Representatives.

Let me establish at the outset: the IIB supports the goals of financial reform—namely, increased transparency; stronger capital and liquidity standards; and reduced risk to financial stability and to the taxpayer. It is also important to make clear that, as with U.S. domestic banks, the U.S. risk-taking operations of international banks are subject to the statutory limitations set forth in the Volcker Rule. While IIB member firms generally share many of the concerns expressed by others regarding the Volcker Rule's impact on their operations, in my

testimony today I will focus on the significant cross-border and extraterritorial effects of the proposed regulations on the head offices and other non-U.S. operations of our member firms.

We have three major concerns:

First, the proposed limitations on proprietary trading and fund activities conducted “solely outside of the United States” will have severe extraterritorial consequences that were not intended by Congress and are not justified by the policy behind the Volcker Rule;

Second, the proposed regulations should provide an exemption for trading in foreign government securities comparable to the exemption for U.S. government securities to avoid unintended adverse effects on foreign government bond markets; and,

Third, the imposition of the proposed complex compliance regime and reporting requirements on the non-U.S. operations of international banks will cause unprecedented extraterritorial interference with those operations and conflict with the regulatory regimes of their home countries.

While the IIB acknowledges the hard work of the Agencies and the challenges faced in developing the proposed rule, we strongly disagree with a number of key aspects of the proposal where we think the Agencies' interpretation is inconsistent with:

the plain language of the statute;

Congressional intent;

the policy objectives of the Volcker Rule; and,

longstanding U.S. policies limiting the extraterritorial scope of U.S. laws.

In our view, the current proposal to implement the Volcker Rule will not advance our shared goals. It may, instead, work to undermine them and ultimately adversely affect U.S. capital markets and economic growth.

Source: Institute of International Bankers.

Kim Olson, partner at consulting firm Deloitte & Touche, says the rule forces banks to recognize where their profits are derived from and to sift through the quantitative metrics to be reported to regulators. “It makes you think about your risk profiles. Some of those metrics are not a bad thing, especially in risk management,” she says.

Meanwhile, Lily Fang of business school INSEAD says the rule has the ability to reduce certain distorted market behavior associated with the timing of the private-equity cycle. In the research paper “Unstable Equity: Combining Banking with Private Equity Investing,” Fang and two other researchers found that banks, being central intermediaries in the debt market, are able to time the credit market and get deals done when credit conditions are favorable to them.

“The Volcker Rule will help reduce this type of timing behavior and dampen the cyclicality of the private-equity cycle,” says Fang. She says the rule can effectively separate banking activities from principal investing activities, the combination of which can lead to conflict of interest. 

For now, market players remain hopeful that the regulators will consider their concerns. “We want to be able to continue to participate in the market, timely execute our clients' trade, have an efficient primary market for issuers, and a secondary market for liquidity,” Koch says.

Unlike some Dodd-Frank rules where regulators are empowered to extend the effective date if the final rule isn't ready, the Dodd-Frank Act forces July 21, 2012, as the effective date, with or without a final rule. Questions remain whether the regulators will have sufficient time to weigh all comments and amend the proposed rule to address the industry's concerns.

“By statute, they are required to review all comments. There will be lengthy discussions on the aggregated issues raised by the market participants,” says Dwight Smith, a partner at law firm Morrison & Foerster.

If a final rule isn't adopted by July 21, that will leave companies uncertain about what regulatory agencies expect them to do next. “I think they will want to release a final rule before the effective date in July. I will speculate that they will want a final rule out before the end of May,” Smith says.