The Volcker Rule and used car dealers
The House Financial Services Committee held a hearing yesterday on the Volcker Rule, a key part of the Dodd-Frank financial reform law. The Volcker Rule attempts to curtail speculating for their own account by the nation’s largest banks, which are backstopped by the Federal Deposit Insurance Corporation (FDIC). It’s a tricky law to implement because the nation’s largest banks also are the largest market makers for most securities, including municipal bonds. The line between market making and proprietary trading can be fuzzy.
The easiest explanation for the role that big banks play as market makers in the fixed-income markets is to think of them as used car dealers. The dealer has a big wad of money and stands ready both to buy and sell cars. Similarly, banks use their big balance sheets both to buy and sell securities. Sometimes the client is a little old lady who just wants to buy $5,000 worth of muni bonds; other times the buyer is a massive mutual fund that wants to sell $200 million worth of Treasury bonds. The risk to the car dealer and the bank is that demand will fall off or their inventory will decline in value while they are waiting for buyers to arrive.
By eliminating the banks’ ability to use their inventory to trade for their own account, the Volcker Rule will cause trading volumes to fall. Yalman Onaran of Bloomberg captured the pain level that banks experience when their trading declines:
The potential loss of revenue for banks has made pushing back against the Volcker rule a lobbying priority. Efforts by Sifma and other groups to modify the proposal come as lenders already are making less money buying and selling securities. Trading revenue at JPMorgan Chase & Co., the largest U.S. lender by assets, dropped 18 percent in the fourth quarter, the bank reported last week. Citigroup Inc. (C), the third-largest, posted a 10 percent decline yesterday.
Some of the trading declines are due to the crisis in Europe, and some due to general market caution. But a lot of the decline should probably be attributed to the fact that banks are not trading for their own account any longer (as they conform to the new rules in advance of implementation). This will make the financial system more stable because Wall Street often tends to herd into the same trades.
As far as muniland is concerned, the Volcker Rule exempts state and local general obligation bonds from the prohibition on prop trading but does not exempt municipal revenue bonds. Industry groups claim that this will create a “bifurcated” market, but it seems the only loss would be for the banks’ profit statement. The other area that has muni market participants up in arms is the prohibition against “tender option bond” (TOB) programs. The Volcker Rule does not allow a bank to deal with a fund that it creates, and TOB programs are trusts that are established to hold long-term municipal bonds and leverage the advantages of short-term financing. Tax-exempt money-market funds like to buy TOB short-term paper, but I’m not sure that is a good enough reason to create a carve-out in the Volcker Rule for them. The financial crisis was intensified by the cross-dealing that banks had done with their affiliates, and the Volcker Rule seeks to reduce this risk.
Much of the concentration in municipal markets comes from the longtime advantages that the biggest banks have had in market making and prop trading. The Volcker Rule will limit the dominance of big banks and, it is hoped, help reduce bond market concentration. In the fight over its implementation, the big players are pushing to maintain the current market structure. To increase the stability of the financial system, parts of the market structure have to be reshaped and rearranged. The proposed Volcker Rule won’t hurt municipal markets, job creation or the economy. But it will hurt bank profits. Expect the fight to go on a while longer.
Federal Reserve Governor Daniel Tarullo: Testimony before the Committee on Financial Services
Americans for Financial Reform: The Volcker Rule and Market Liquidity
Darrell Duffie: Market Making Under the Proposed Volcker Rule
Cadwaladar: A Critical Analysis of the Potential Impact of the Volcker Rule on Municipal Bonds
CCH Federal Banking Law Reporter: Regulators Acknowledge Volcker Rule Challenges