The Volcker rule’s loopholes

By Felix Salmon
February 3, 2010
Paul Volcker's long NYT op-ed last weekend, and his testimony to the Senate banking committee this week, did very little to clear up a lot of the uncertainty over what exactly the Volcker rule comprises. That was probably deliberate, given the degree to which Chris Dodd is skeptical that any such rule can be implemented at all. But the contours of a Volcker rule are slowly emerging all the same, and that they carve out two enormous loopholes.

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Paul Volcker’s long NYT op-ed last weekend, and his testimony to the Senate banking committee this week, did very little to clear up a lot of the uncertainty over what exactly the Volcker rule comprises. That was probably deliberate, given the degree to which Chris Dodd is skeptical that any such rule can be implemented at all. But the contours of a Volcker rule are slowly emerging all the same, and that they carve out two enormous loopholes.

Firstly, the Volcker rule seems to apply only to depositary institutions: if you don’t take deposits, then you’re exempt. The result is that it’ll be easy for Goldman Sachs and Morgan Stanley to get around the rule just by returning their current (tiny) deposit base and voluntarily withdrawing from access to the Fed’s discount window.

But the point here is that banks with deposit bases are already insured and regulated, by the FDIC. The definition of a bank isn’t an entity which takes deposits; it’s an entity which borrows short and lends long. So long as the likes of Goldman Sachs can fund themselves in the wholesale market and continue to lend money to large clients in things like the syndicated loan market, they’re banks, and they should be subject to rules like Volcker’s which apply to banks.

Secondly, it seems that banks might be allowed to continue to own hedge funds, private-equity funds, money-market funds, and the like, just so long as they’re run for clients, with client money, rather than being vehicles for the investment of the bank’s own capital.

This too is dangerous, because the history of the financial crisis is clear: Bear Stearns ended up bailing out its internal hedge funds even when it didn’t legally have to. Large banks ended up bailing out clients who invested in auction-rate securities. Fund managers ended up putting up their own capital to stop money market funds from breaking the buck. Banks with SIVs ended up bringing them onto their own balance sheet, taking enormous associated losses. Etc etc. Essentially, a bank might say that it has no exposure to such things, and that all the risk lies with its investing clients. But that’s never, ever true.

So while I think that the Volcker rule is a good idea, I also think that it has already been diluted to a point at which it will do very little good. If prop trading is a problem, it’s much more of a problem at Goldman Sachs than it is at Wells Fargo — yet the Volcker rule would apply to Wells Fargo and not to Goldman Sachs. Similarly, if owning hedge funds is a problem, it’s a problem whether or not the bank’s capital is nominally invested in the fund, but the Volcker rule gives banks an easy way to wriggle out from under it, simply by withdrawing their own investment.

So my feeling is that the Volcker rule probably won’t make its way into law, and that it’ll be largely toothless if it does. A shame.


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I’ve been saying for some time that the real problem is the pathways of contagion in a financial crisis. You point out some of the ones which operated in the recent dustup. Like those, some of the most important pathways happened to be indirect and not obvious ex ante, like the way banks and hedge funds, faced with securities and derivatives losses resulting from plummeting real estate prices, started liquidating securities and derivatives in unrelated markets to meet margin calls and boost capital. This just accelerated and spread the crisis to institutions and markets which on the face of them should not necessarily have been affected, and the crisis fed on itself.

I do not know how one can catalogue all such pathways, or, indeed, if one could, whether regulators could actually do anything to shut them down or dampen their effects. I think it may be an ineluctable feature of a globally networked financial system interlinked in real time.

For example, even if one could satisfactorily separate all proprietary trading operations from banking institutions, you would still leave an extremely important pathway open in the form of banks’ prime brokerage lending exposure to independent hedge funds. After all, somebody needs to supply hedge funds with leverage. Who else can do it but the banks? And such an arrangement can do very nicely to create a near or actual global panic, thank you very much. Anyone remember Long-Term Capital Management?

However, it is clear that too much short-term leverage, especially at systemically critical commercial and investment banks made the problem worse and accelerated the collapse. I tend to think the apparent principle behind the Volcker Rule–walling off supposedly dangerous activities from the banking system–would be far less effective than limiting overall leverage, especially volatile short-term leverage, at systemically important financial institutions. Whether one does that by strictly limiting the size of the biggest banks to no more than $500 billion, as you have proposed in the past, or by allowing banks to get as big as they like as long as they have robust levels of permanent capital supporting their balance sheets I think can be a matter for reasonable disagreement.

Posted by EpicureanDeal | Report as abusive

Text of H.R. 4191: Let Wall Street Pay for the Restoration of Main Street Act of 2009

‘(a) Imposition of Tax-
‘(1) STOCKS- There is hereby imposed a tax on each covered transaction in a stock contract of 0.25 percent of the value of the instruments involved in such transaction.
‘(2) FUTURES- There is hereby imposed a tax on each covered transaction in a futures contract of 0.02 percent of the value of the instruments involved in such transaction.
‘(3) SWAPS- There is hereby imposed a tax on each covered transaction in a swaps contract of 0.02 percent of the value of the instruments involved in such transaction.
‘(4) CREDIT DEFAULT SWAPS- There is hereby imposed a tax on each covered transaction in a credit default swaps contract of 0.02 percent of the value of the instruments involved in such transaction.
‘(5) OPTIONS- There is hereby imposed a tax on each covered transaction in an options contract with respect to a transaction described in paragraph (1), (2), (3), or (4) of–
‘(A) the rate imposed with respect to such underlying transaction under paragraph (1), (2), (3), or (4) (as the case may be), multiplied by
‘(B) the premium paid on such option.

Does anyone think this will see the light of day or have much impact either?

Posted by polit2k | Report as abusive

Although the current administration wants to give the impression of going after the corrupt banking system, it is looking more and more like our current leader was hired by the big banks to help them acquire an even greater banking monopoly. Hundreds of small banks were eaten up by the large ones last year with hundreds more ready to follow. These types of rules will only exacerbate the situation. It will give the allusion of reeling in the banks when it will actually be giving them more power. I believe the banking monopoly issue will be the defining issue of the current administration whether anyone acknowledges it or not. It is sad to see no media reporting on this consolidation of power to the banking elite about which Abraham Lincoln so eloquently warned us. But, I guess, I might not either if I was them. You do not bite the hand that feeds you.

Posted by absolutely | Report as abusive

EpicureanDeal: thanks for that, now I get it, this must be published a million times so that the world understands what it means to be caught short.

polit2k: I think Felix was unkind not to include dentures, sorry, debentures.

absolutely:Consolidation good, assassination bad, especially that of the character.

Posted by Ghandiolfini | Report as abusive

Did Volcker quote John Hempton (Bronte Capital)- but not attribute it ?

Volcker, as reported by the Guardian, before the Senate banking committee (today):

“Battling criticism from Republican ­lawmakers, Volcker told the Senate’s banking committee it was entirely ­possible to define banks’ “proprietary trading”, quipping that risky financial activity was “like pornography: you know it when you see it”.”

when I saw this reported I thought I had read it before ………………………………….

John’s article posted on his website Bronte Capital on Friday, Jan 22, 2010:

“Friday, January 22, 2010 – Bronte Capital Website”
What is proprietary trading?
Somewhere in the debate about prohibiting proprietary trading in certain banks we will need a decent understanding of what proprietary trading is. So I thought I would illustrate the difficulties.
Imagine a suburban bank which takes deposits and makes mortgages.
The deposits are primarily at-call and pay a floating interest rate. Legally they bank has overnight money – and if interest rates rose then the next day the customers could (in theory) all withdraw their money and/or ask for a higher interest rate. The bank does not really know what interest rates it will be paying next week let alone in three years.
In reality the customers of the bank are sticky. There is no way that everyone will pull their money in response to a short term rate rise. The funding of the bank is of uncertain duration.
On the asset side the bank lends on fixed rate but refinanceable mortgages. The bank really has no idea how long the mortgages will last. If rates go down they might all be refinanced tomorrow. People might just sell all their houses and repay their mortgages. In reality however the customer are likely to be somewhat sticky. On the asset side the bank has uncertain duration.
This plain vanilla bank has interest rate risk. If rates rise their funding costs will rise relative to their asset yield. If rates fall their assets will refinance. Their funding cost might also fall – but at the moment the funding cost seems pinned by the zero-bound.
Some hedging of interest rate risk here seems entirely sensible. Banks (and more often S&Ls) have failed in the past because they failed to hedge this sort of interest rate risk. However as both the assets and liabilities are of uncertain duration there is no way of knowing just how much hedging is required. There is a choice here – it is a proprietary choice (in that the bank will trade off hedging costs against profits). And there is no easy way to legislate that choice away.
I have even seen a bank swap its fixed rate subordinate funding (fixed rate preferred shares) into floating rate and call it a hedge. That looked like proprietary trading to me as it earned a profit (the yield curve was steep) and the bank was playing the yield curve very heavily in advance of that hedge. The so called hedge increased the risks the banks faced if short rates rose. The auditor signed it off as a hedge.
If the auditor, the bank and I disagree as to what is a hedge in the simplest of examples then I have no idea how we are going to find a legislative solution in complex examples.
Real prop trading is like pornography. I know it when I see it.”


Posted by RLWB | Report as abusive

Darwin explained that life (as in the ocean reef or the human city) is a great competitive struggle to survive. And that the appearance of new successful species means that some other species are no longer competitive, and then become extinct.

Adam Smith said the same about businesses. New businesses evolve, and eventually most businesses eventually become extinct.

Individuals, like myself, and you, the reader, eventually become old, and die. Our eventual dying is good for the health of the human society.

The Fed, by stepping in to save wealthy investors, many of the very wealthiest families in the world, who made terrible investment decisions, has brought great harm to society. Saving the jobs of the bank executives who gambled like drunken sailors, and putting them back in power, has done great permanent damage to our society.

Now, everywhere in our financil system there is dead wood, that is rotting the healthy wood around it.

Posted by AdamSmith | Report as abusive

All this banking micro-management is just never going to work in the long run. You can’t micro-manage risk out of the system. If US government is going to provide an implicit guarantee, which frankly they never are going to get out of doing that since Tarp was created, then just charge the players for the insurance just as the FDIC does. Insurance do this all the time, charge premiums, then pay claims when disaster hits. Call it the FIIC (Financial Institution Insurance Corp) or whatever and all players will be insured by the federal government. If you are not ensured than everyone knows and they know the risk they are taking and that the government with not make you whole when disaster hits.

The real issue in all of this is the “AAA” never meant “AAA”. What really should happen is “AAA” should mean government backed. Everything else is below that and assume the risk.

Posted by freedomadvocate | Report as abusive

First let us agree that the objective of all the proposed regulation is to lower the RISK to the system thereby lowering the VOLATILITY thereby lowering the RATE of interest rates thereby allowing for corporations to plan the cost of capital investments/projects that are more closely aligned to their realized cost and original ROI assumptions. The result is confidence in corporate leaders to deploy capital and employ workers. While this will not eliminate business cycles, it will certainly decrease the frequency and amplitude of business cycles. This is in the idiots that currently populate the investment community and future generations best interest.


If a bank determines through their expertise in banking and judging the direction of interest rates that it is exposed to an asset liability duration mismatch then they should be allowed to hedge based on their understanding of the market. A permanent audited account should be created where all gains and losses from the banks hedging activities should be accounted for and are not to be used for any other purpose other than to offset the losses of the portfolio duration. If this is done correctly than hedging gains/losses will nearly completely offset the affects duration mismatch.

However, if a bank is constantly needing to hedge their duration mismatch then perhaps the bank officers are struggling with how to effectively run a bank. The regulating authority will then need to review whether the bank should be allowed to remain in operation.

This will take more the a Ronald Reagan approach to bank auditing.

Posted by csodak | Report as abusive

If this administration were serious about addressing the root of the economic problem, the first thing would be to restore Glass-Stegall. Sadly, the average American doesn’t know what Glass-Stegall was, why it was instituted, who traitorously repealed it, and how its removal enabled large American banks and insurance companies to run wild in the midst of regulators who wouldn’t regulate. Trotting Volcker out gives the appearance of an administration that cares about fixing our economic problems, but it’s only windowdressing intended to fool the public. The bankers will prevail, continuing to enrich themselves. Any new bills to rein them in will be fraught with clever loopholes written with the help of the big banks’ lobbyist/lawyers and their Senate puppets on both sides of the aisle. It’s important to vote your Senators out, if only to make the bankers’ job of buying their cooperation more challenging.

Posted by billybob1 | Report as abusive

Voting representatives out of office will not solve the problem. Have you looked at the candidates that would replace them? The majority of candidates are of the same ethical makeup.

Posted by csodak | Report as abusive

the problem is hankie-panking around with these sleezoid banks and banking families.

the solutions are simple:

IF too BIG to fail, THEN bust it up!

IF won’t reform, THEN nationalize it!

we are in three wars (afg, irq, pak) and a recession. obama needs to take emergency action against these banks.

(happy hunting!)

Posted by jborrow | Report as abusive

TED: “somebody needs to supply hedge funds with leverage”

Why? I’ve never earned anything off a hedge fund. I could care less whether they have leverage. (Yes, I know if we take away their leverage, they won’t be able to inflate the value of stocks, etc, and Main Street will see the consequences. But isn’t bailing out pension funds directly better than seeing how long we can keep the bubble inflated.)

How about we just extend the Fed’s Regulation U (on stock margin limits) to everything, every bank client and every asset. It would probably be a good way of limiting overall leverage.

Posted by csissoko | Report as abusive

I agree to vote the bums out….if nothing more than to decrease the corruption continuity. I still advocate that none of the risks were properly disclosed. People of free will are allowed to take risks in a free society. You can’t legislate risk away. You just provide an explicit guarantee to eliminate it. The FDIC provides a guarantee that I believe has worked. In 1984 I my checking accout was in a savings bank in Maryland. The bank flopped, I walked up to the door one day and a note said come back in week to get your money. I didn’t panic I just waited a week and was made whole by the full faith and credit of the US government. A savings account and cash have backing of the government and are effectively riskless.

I do agree the vampire squids need reigning in to the extent that are creating a systemic risk, but I have not seen anyone losing money with their money in a saving account throughout this crisis. The second you take your money out of a saving account buy some other security apart from government issued debt you are taking risk. (You could argue that government debt is risk at this point – but that is whole other post) Frankly, getting a mortgage at 10% down is risk, banks only do this because they get the asset when the borrower walks. The argument that we are going to regulate vampire squids is just ludicrous. Predators exist and they always will. 1920s bucket shops, the 1960s securities fraud in the nifty fifty, insider trading scandals in the 80s, junk bonds, internet stock fraud in the 90s, enron and on and on….throughout all these period regulators were ringing there hands and it never changes.

Obama, Volker or whoever can say they are going fix the problem, but history shows the vampire squids will find a way to stay alive. The key for the every man is get educated and know when you talking to a vampire squid.

Posted by freedomadvocate | Report as abusive

This is one reason why I think we would be better off changing factors in the risk-based capital formulas — reflecting the risks being taken by banks more accurately. Also, equity-like risks should be treated as a deduction from equity, and/or kept in a separate subsidiary. Holding companies could own anything, but would never be bailed out. Cross-shareholdings and other incestuous capital structures would be banned.

And then, above all, lower the amount of leverage they can employ, including eliminating counting anything else as equity except tangible common equity.

Posted by DavidMerkel | Report as abusive