“Volcker rule” exemption for liquidity management remains half-thought

By Guest Contributor
September 19, 2012

By Bora Yagiz

NEW YORK, Sept. 19 (Thomson Reuters Accelus) - The question what distinguishes a “trading account” from a legitimate liquidity management program will be a primary concern as no less than four regulators, namely the Federal Reserve, the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, finish work on the “Volcker rule” limiting risky trading by banks. The regulators jointly proposed last year the provisions for implementing section 619 of the Dodd Frank Act. Final rules are expected by year end.

The July 2012 statutory deadline for what is commonly referred to as the Volcker rule has already been missed, and the 298-pages of proposed rules have attracted more than 17,000 comment letters and sparked a heated debate across the industry. This is because the regulators aim for a complete overhaul of trading activities by severely restraining any “banking entity” from “proprietary trading,” thereby preventing undue risk exposure of consumers’ and taxpayers’ money.

The devil will be in the interpretation of many of these rules. The definition of “trading account” will likely be the most critical premise, as the rest of the rules will be built upon it.

Since the inception of the Volcker rule, named after former Federal Reserve Chairman Paul Volcker, who promoted it, much of the discussion has revolved around what constitutes “proprietary trading.” Dodd-Frank defines it as “engagement in an activity by a deposit-taking institution as a principal for its trading account in the purchase or sale of a security, derivative, future or an option contract. “

The interest in proprietary trading is not surprising, as significant losses incurred by banks during the recent financial crisis came from proprietary positions in trading accounts, mostly from mortgage-backed and asset-backed bonds tied to toxic loans. More recently, JPMorgan’s “London whale” trade debacle, where the company lost $5 billion, raised the question of whether it was a legitimate form of portfolio hedging or a speculative play on short-term price movements.

PERMISSIBLE ACTIVITY

The Volcker rule delineates three distinct areas of permissible trading activity, namely, hedging, market-making, and underwriting. While activities that mitigate specific risks associated with the institution’s other positions — without giving rise to new exposures — are to qualify as hedging under the rule, traditional market making and underwriting are only to be allowed as long as they do not exceed the reasonably expected near-term demands of counterparties; and the revenue they generate does not primarily accrue from appreciation of the positions’ value.

As such, the bulk of the Volcker rule is devoted to resolving the “gray area” in-between, namely, that which is open to interpretation through a complex array of conditions.

However, all these elaborate details and intricacies surrounding permissible activities can be moot if a banking entity is able to establish that the account in question falls outside the scope of the definition for the “trading account.”

EXEMPTIONS FROM “TRADING ACCOUNT”

Four specific areas of exclusion exempt an account from being defined as a trading account.

Three of them are straightforward. If the position taken by the bank arises from a repurchase or a reverse repo agreement, or from a securities-lending transaction, or is in connection with clearing a derivative or a security transaction in the case of a registered clearing entity with the Commodity Futures Trading Commission or the SEC, then the account is considered not to be a trading account.

The fourth area of exclusion is less clear-cut. It exempts from the trading accounts definition positions taken in conjunction with “bona fide liquidity management.” But it does not clearly define such liquidity management. A balance must be struck between allowing banks enough flexibility in running their traditional asset-liability management (ALM) programs and preventing possible abuse via proprietary trades under its guise.

The language of the Volcker rule poses some potential for confusion.

For example, the rule says banks must use “highly liquid” assets in its liquidity-management activities, but does not say what it means by highly liquid. A highly liquid asset is defined elsewhere in Dodd-Frank (as under section 165 for the purposes of stress testing) as any cash-like debt instrument of the U.S. government or agency, or as any other asset with low-credit and market risk, traded in an active secondary market, and that has historically been purchased during times of flight to quality.

Assets in accounts not considered trading accounts should not show “appreciable” profit, but that term also is left undefined.

Similarly, the phrase “short-term” is vague in the discussion of determining what is a short-term holding in the context of liquidity management, although it is clearly defined as “60-days or less” under a “rebuttable presumption for certain positions,” section for proprietary trading of the Volcker rule.

True, banks are unlikely to have much flexibility using their “liquidity pool” accounts for trading purposes, even if regulators do not necessarily draw a specific list of “highly liquid” instruments that may be used for liquidity management purposes. Almost certainly, Treasury and government agency debt would be accepted as meeting the definition, while instruments such as municipal or corporate debt in this account could potentially raise a red flag. After all, mortgage-backed securities, considered to be liquid by the market, did prove to be otherwise during the financial crisis.

Guidance here would be useful nonetheless.

“Why not simply use the Fed’s proposed criteria for Basel III Liquidity Coverage Ratio?” asks Marc Jarsulic, Chief Economist at Better Markets. Indeed, the regulators may take a cue from the Basel Committee’s continuing discussions in drawing the list of eligible highly liquid assets banks can use for the purposes of this critical liquidity matrix.

Aside from the language, the trading-account exclusion has also caused concern. Volcker rule supporters have warned that the trading account exclusion may be too broad. But some critics have found it too narrow.

For instance, U.S. Sens. Jeff Merkley and Carl Levin have argued that repo, reverse repos, spot commodities and currencies should not be part of exclusions from the trading account. Some bankers, on the other hand, found it puzzling that the exclusion covers only the liquidity management aspect of ALM, disregarding its other critical components such as interest rate and maturity management.

“The reason to include the liquidity management exclusion is certainly correct, and it should be as simple and broad as possible to avoid any perverse effect on liquidity management practices of the banks,” says Karen Shaw Petrou, Managing Partner at Federal Financial Analytics. “Given the guidance provided by global and domestic rules on liquidity management, the regulators would be well-equipped to detect any abuse,” Ms Petrou adds.

Christopher Laursen, Vice-President at NERA Consulting and former manager of risk policy for the Federal Reserve, remains skeptical. “Though a liquidity carve-out, particularly within the available-for-sale portfolio is necessary, the fragmented structure of regulatory oversight and lack of experience of many supervisors may negatively impact the ability and willingness of supervisors to appropriately limit liquidity pools in aggressive institutions,” Mr. Laursen says.

A possible solution is for relevant regulatory agencies to form a specialized joint team to review firms’ designated liquidity pools periodically, to ensure that pools are appropriate and that rule interpretations are consistent across firms.

The liquidity management-exclusion in the definition of trading account meets a need by banks. How much it will be susceptible to abuse will ultimately depend the final rules regulators decide on.

(Bora Yagiz is a New York-based regulatory intelligence expert for Compliance Complete, specializing in banking. Mr. Yagiz has held positions as a bank examiner for the Federal Reserve Bank of New York, as senior consultant with Ernst & Young and vice president at Morgan Stanley. Follow Bora on Twitter @Bora_Yagiz.)

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