THE MUCH-MALIGNED Volcker Rule finally came into existence last week despite a barrage of lawsuits, much gnashing of industry teeth, and countless protestations that the rule merely cements how little regulators, policymakers – and Paul Volcker – really understand about the functioning of capital markets.
There’s probably an element of truth in all of that, notwithstanding the fact that at a six-miles-high level you can understand the motivations of lawmakers to cut what they saw as the pernicious interconnectedness of the financial system that stunted risk transfer and drove up systemic risk.
It’s water under the bridge – for now, anyway. In all honesty, banks have long shuttered their prop trading desks and severed links to hedge funds and private equity firms, so the rule’s arrival passed without fanfare. There remains, and there will always be, a lack of clarity around exactly where the hard line lies between prop trading and market-making, for example, or how flexible the rule is around the definition of entities such as CLOs, so it’ll be a tedious game of endless back-and-forth between banks and regulators. But the intent is clear.
Volcker has, of course, conspired with more stringent capital and other rules to kill liquidity in the bond market. Illiquidity has become a poster-child of unintended consequences and my sense is that over time we’ll see some regulatory effort geared at easing a situation that has become chronic. But that’s a story for another day.
Volcker also plays directly into the broader theme of business separation and ring-fencing, a top-five industry topic for years now and still very much front-of-mind. So while the Fed continues to bang the drum of more capital for its G-SIBs, John McCain and Elizabeth Warren continue to bang the drum for the passing of their 21st Century Glass-Steagall Act of 2015, following similar efforts in the UK and the EU.
(As an aside, I gather that Gunnar Hoekmark’s efforts to marshal ring-fencing in the EU – but not the UK, which earned a carve-out in favour of Vickers – is running into trouble. But that’s also a story for another day).
I DON’T THINK anyone can have any problem with rules limiting the ability of banks to hand their prop traders insured deposits as speculation fodder; or with the idea that governments shouldn’t put taxpayers on the hook to bail out reckless speculators or those engaged in notionally high-risk activities.
But the basis of much of the law-making – characterising retail and consumer banking as safe and investment banking as risky – is facile and dangerous. Consumer and small-business lending is very risky, unlike best-efforts underwriting, agency broking, market-making or event-driven advisory.
I take issue with the contention made in the new Glass-Steagall bill, quoting Vickers and Liikanen, that there is “no inherent reason to bundle ‘retail banking’ with ‘investment banking’ or other forms of relatively high-risk securities trading … ” I say with requisite safeguards and transparency around cross-subsidies and capital allocation, I don’t see any reason for them not to be bundled, if nothing else to safeguard the notion of diversified and counter-cyclical revenue streams.
I’m also mightily tired of this notion, re-run in the new Glass-Steagall Bill, that banks need to be channelled into socially valuable banking activities. I just don’t know what that means.
The Bill will kind of force business separation between insured depositary institutions on the one hand, and insurance companies, securities dealers and swaps entities on the other. I say kind of because, while insured banks won’t be permitted to underwrite, they will be allowed to engage in securities dealing on behalf of clients and buy securities for their own account, up to 10% of their paid-in capital (though not structured or synthetic products).
Volcker has, of course, conspired with more stringent capital and other rules to kill liquidity in the bond market
FINALLY, ON CAPITAL, the Fed this past week approved a final rule forcing capital surcharges on its GSIBs (BAML, BNY Mellon, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street, and Wells Fargo) using a formula that takes into account their degree of systemic importance discounted for their probability of default. Estimated surcharges for the eight GSIBs range from 1% to 4.5% of each firm’s risk-weighted assets. The idea is to reduce the systemic fallout from the failure of a GSIB to that of a model non-GSIB bank holding company.
The surcharges will be phased in beginning on January 1 2016 and becoming fully effective on January 1 2019. Janet Yellen said requiring banks to bear the costs that their failure would impose on others will confront them with a choice: “ … they must either hold substantially more capital, reducing the likelihood that they will fail, or else they must shrink their systemic footprint, reducing the harm that their failure would do to our financial system. Either outcome would enhance financial stability,” she said.
The Fed has put forward two methods for calibrating the size of the surcharge: one using BCBS metrics (size, inter-connectedness, cross-jurisdictional activity, substitutability, and complexity); another (which will result in higher surcharges) that replaces substitutability with a measure of the firm’s reliance on short-term wholesale funding. Check out the White Paper that describes how the surcharges will be calibrated.
As a final point, and taking everything above into account, I continue to be left with a sense that the separate regulatory streams should be spending more time taking each other into account i.e. if Volcker has put paid to prop trading and links to third-party funds, shouldn’t that obviate the need for new Glass-Steagall?
In short, Dodd-Frank, capital charges and surcharges, and leverage and liquidity rules have rendered the banking sector a safer place. But have they led to overly engineered, strait-jacketed solutions that poorly serve the economy?