Volcker Rule unexpectedly revived by Dodd bill
Paul Volcker’s proposed ban on banks’ proprietary trading or owning hedge funds or private equity funds has been unexpectedly revived in the financial regulation bill published by Senate Banking Committee Chairman Christopher Dodd yesterday.
The Volcker Rule’s surprise survival comes despite fierce opposition from the banking industry and after many commentators had written it off as a short-term political gimmick in the wake of the shock election defeat in Massachusetts. Dodd himself had appeared lukewarm.
In fact, Section 619 of the bill (“Restrictions on Capital Market Activity by Banks and Bank Holding Companies”) would give legislative effect to the proposals almost exactly as outlined by President Barack Obama at the press conference in January.
BANS ON PROP TRADING, HEDGE FUND SPONSORSHIP
Section 619 (b) instructs the new Financial Stability Oversight Council (FSOC) to issue rules that “prohibit proprietary trading by an insured depository institution, a company that controls an insured depository institution or is treated as a bank holding company”.
That covers pretty much every major bank in the United States as well as former securities firms Goldman Sachs and Morgan Stanley that converted to bank holding companies and then financial holding companies to access Federal Reserve support at the height of the crisis. Just in case they are tempted to convert back, the bill contains another provision, Section 117, ensuring the rules apply to them anyway.
Proprietary trading is defined in subsection 619 (a) as “purchasing or selling, or otherwise acquiring or disposing of, stocks, bonds, options, commodities, derivatives or other financial instruments” unless the activities are conducted “on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of customer relationships, including hedging activities”.
There is a special exception for investments in U.S. Treasury securities, as well as agencies fully guaranteed by the United States, certain instruments issued by Ginnie Mae, Fannie Mae and Freddie Mac, as well as states and municipalities.
In similar vein, Section 619 (c) directs the Council to issue regulations that “prohibit” the same types of banks and financial companies from “sponsoring or investing in a hedge fund or a private equity fund”.
The meaning of hedge fund and private equity fund is defined as “a company or other entity that is exempt from registration as an investment company” under the Investment Company Act 1940, or any “similar fund” as determined by federal banking agencies.
Later in the bill, Section 619 (g) (C) gives the Council the power to make recommendations prohibiting activities in subsections (b) (prop trading) and (c) (hedge funds and private equity) above a certain threshold amount and impose additional capital requirements on activities below that threshold amount.
Crucially, it would allow the Council to recommend banks be permitted to continue with some minimal amounts of prop trading, subject to a capital penalty, while continue to prohibit large volumes. It could help sidestep the thorny issue of how to identify prop trades from ordinary market-making. The Council could simply allow banks to do some small volumes of prop trading so long as it was incidental to customer activities.
CONTROLS EXTENDED TO SIGNIFICANT NON-BANKS
In some respects the Dodd bill goes further than the original Volcker proposals. Section 619 (f) would impose additional capital requirements and specify additional quantitative restrictions on any systemically significant nonbank financial company supervised by the Board of Governors of the Federal Reserve under Section 113.
Section 113 brings nonbank financial companies under Fed regulation based on leverage, the size of assets and liabilities, off-balance sheet exposures and interconnectedness.
The combination of Fed regulation under Section 113 and additional capital requirements and quantity limits under Section 619 (f) is designed to capture the proprietary trading activities of major non-bank institutions such as AIG, but it could also capture hedge funds such as LTCM that become large enough to become systemically important.
Once again there is a special exemption for prop trading in U.S. Treasury securities, agency paper, and the three big mortgage consolidators as well as states and municipalities.
DETAILED IMPLEMENTATION LEFT TO THE COUNCIL
In a bid to defuse industry opposition, and anticipate objections that a simple prohibition is unworkable, the bill grants significant discretion to the Council over implementing the Section 619 prohibitions and capital requirements.
The Council has six months to study the problem, including how to distinguish prop trading, and make recommendations or propose modifications to the definitions, prohibitions and limits that “would more effectively implement” Section 619.
Relevant regulators have a further nine months to issue joint regulations implementing the various aspects of Section 619. After a two-year transition period, prop trading activities as well as hedge fund or private equity sponsorship will be banned, with the possibility of an extension for individual institutions only if banking regulators determine it would “not be detrimental” to the public interest.
Leaving detailed implementation to the FSOC and banking regulators could give the industry some flexibility over the how the ban is implemented. Lobbyists will be deployed in full force to secure the broadest possible definition of market-marking and customer-related trading and prevent regulators taking an intrusive interest in which trades are for customers and which are for the banks’ own account.
In practice, it may be very difficult to distinguish proprietary trades from those which “facilitate customer relationships”. The Council and individual regulators may take a relatively relaxed approach in this area — banning only the most egregious prop activities.
REGULATORS’ DISCRETION IS CAREFULLY LIMITED
But if the industry thinks it has successfully emptied the Volcker Rule of any practical meaning, it should think again. While the bill would leave detailed regulation to the Council, the bill contains a long list of objectives to which the Council and regulators must give priority.
Objectives include safety and soundness of depository institutions. Protecting taxpayers and enhancing financial stability. Limiting the inappropriate transfer of federal subsidies from institutions that benefit from deposit insurance. Reducing inappropriate conflicts of interest between banks and their customers. And limiting activities that have caused undue risk or loss or might reasonably be expected to do so in future.
In a limited nod to the industry’s arguments, the Council is directed to take into account any effects that raise the cost of credit and other financial services, or reduce their availability. But that is all.
Regulators have considerable discretion over how to give practical effect to the will of Congress, and the courts will give them some leeway. What they cannot do is to ignore the text of the statute completely or adopt regulations that conflict with its clearly expressed terms.
A GOOD START
Overall, Dodd’s bill looks like a sensible and careful effort to give meaning to the Volcker prohibitions. It leaves unresolved the question of exactly how to distinguish a prop trade from ordinary market making. The distinction may never be clear in practice; but asking for an exact definition is a counsel of perfection.
Instead the bill would clearly express the sense of Congress that institutions benefiting from lender of last resort protection should not engage in large amounts of prop dealing or hedge fund and private equity activities subsidised by the taxpayer. It would reverse the burden of proof by giving regulators power to challenge the banks prop activities and force the banks to justify them.
For most institutions, Section 619 may not make much difference in practice (though Goldman Sachs and one or two other banks will have to close or spin off their affiliated hedge funds). But it will give regulators power to step in to prevent another LTCM or AIG, or banks running large speculative positions using their privileged access to taxpayer backing.