The Trouble with the Volcker Rule
"I believe that the officers, and, especially, the directors, of corporations should be held personally responsible when any corporation breaks the law."
– Theodore Roosevelt, speech at Osawatomie, Kansas
"The New Nationalism" August 31, 1910
For a while now I have been saying that the Volcker Rule is a bad idea. I share the respect and admiration we all have for its namesake, former Fed Chairman and full-time public citizen Paul Volcker. But Volcker has never been a hawk on bank superivision, especially when it comes to large banks like his former employer Chase Manhattan Bank. I called Volcker “the father of too big to fail” in my 2010 book, Inflated: How Money & Debt Built the American Dream. The epyhonimous rule that now terrorizes much of the financial industry is thus especially incongruous and for the following reasons.
The Volcker Rule seeks to forbid banks from acting as principal in the financial markets for tactical trading gains of any time duration, limiting the investments by the bank to held-to-maturity positions for the corporate treasury. Most of the comments by the industry, media and other observers have focused on the sales/trading area of the large universal banks affected by the Volcker Rule, but the changes imposed by this draconian prescription also impact the activities of the investment side of the house. Hold that thought.
In conceptual terms the Volcker Rule is a step back towards the 1930s era Glass-Steagall separation of investment and commercial banking, but only a half-step and this is the crucial point. The Volcker Rule imposes activity limits on the entire bank without separating the agency and principal functions into different corporate buckets with separate capital in a legal and financial sense. The Volcker Rule focus on imposing the limitation upon the whole organization does great mischief, as noted by the hundreds of public commenters on the rule. A good summary of the Volcker Rule from Skaden Arps is below:
Keep in mind that most of the capital in a bank is meant to support principal risk taking by the bank, not customers, in the form of either lending or investing, while the agency activities for customers such as brokerage, trust and asset management are relatively less capital intensive, like an order of magnitude less. By not bifurcating the capital inside the large universal banks between the majority of which is supposed to support principal risk taken in the credit markets and that lesser portion needed to support customer facing activities, the Volcker Rule by definition must reduce liquidity to the financial markets. All together now: “Duh.”
Last week I spent a couple of hours listening to the head of credit risk at one of the largest banks in the world describe how his lawyers are caught in the crossfire between federal bank regulators and the SEC over what constitutes principal trading for purposes of the Volcker Rule. Of note, a related issue being brandished with great effect by the bank's tormentors at SEC is whether a bank is trading its own account based upon material non-public information (MNPI) under any circumstances.
Under the Volcker Rule, the bank cannot make markets in any of the securities it has traditionally traded. If the bank does make a trade for its own account, it must not only justify the action under the Volcker Rule limitations, but must also prove that neither the bank nor its counterparty were in possession of MNPI. Even if a party inside the bank unrelated to the trade had such MNPI, the bank's lawyers or regulators might object. Thus the investment side of the bank has been presumed to be guilty and as a result is shut down completely.
And under the equally idiotic liquidity rules of Basel III, the bank cannot offer credit in the interbank market unless the facility is 100% backed by liquid assets. Since the Fed has interest rates at zero, the Basel III liquidity rules essentially want banks to take a negative carry position to fund interbank lending at zero effective yield -- thus there is no interbank lending. JPM CEO Jaime Dimon confirms same in the bank's latest earnings call when he says there is no interbank lending w/o collateralization. In both cases, a reduction in overall liquidity to the market must be the result of Basel III and the Volcker Rule.
Now consider the trading and investment side of JPM, which accounts for about a third of the bank's $2 trillion in total assets vs. about the same measure of loans. The other third of JPM’s assets is miscellaneous stuff we’ll discuss later. Pre-Volcker rule, JPM had dozens of traders working for the chief investment officer of the bank, trading government and agency debt, as well as corporate equity and debt securities for the bank's investment needs. Most of them had allocations well into triple digits and a mandate to generate income in long-term positions in corporate and even bank paper.
While JPM was not a market maker per se, JPM and the other large universal banks provided extensive liquidity to these markets pre-Volcker Rule, much more than say a mutual fund of similar size would afford. JPM actively traded these markets because it wanted to keep abreast of the markets, a prudent risk management policy given the size of the portfolio. But in the age of the Volcker Rule and Basel III, JPMorgan has laid off several dozen traders.
Like all of the other universal banks, the investment side of JPM will now only operate in the corporate and bank securities markets to purchase for held-to-maturity positions. All day-to-day tactical trading around the CIO's treasury book at JPM has ceased.
Again, the obvious and inevitable result is less liquidity in the markets and particularly the market for securities issued by US banks, where JPM and other larger institutions are large investors. One of the ironies of the Volcker Rule is that it is actually hurting market liquidity for smaller banks which cannot easily access the capital markets. Some of the market participants I have spoken to directly say that 1/3 of the liquidity in US bank securities has disappeared due to the Volcker Rule. Hopefully the proponents of amending Reg A to increase the size of this exemption to the 1933 Act from $5 million to $50 million or more will go through and partially offset the damage from the Volcker Rule to the markets for small bank securities.
But the real irony of the Volcker Rule in the wake of the financial crisis is that Congress adopted the proposal in the first place. The actual, well-documented problems of the financial crisis came from the sales and syndicate desks of the major banks, both for cash securities and derivatives. Front running customer orders, as the Volcker Rule seeks to limit, is a sublime concern compared with losses from deceptive and fraudulent RMBS, CDOs and endless derivations.
Focusing on the principal activities of the banks w/o addressing the creation and sale of fraudulent securities based on home mortgages and other assets is a major omission of the Dodd-Frank law. Indeed, one can see the Volcker Rule as a diversion from the real problem over at the syndicate desk, much the same way that the bluster around centralized clearing of OTC credit derivatives misses the point of questioning the existence of the cash-settlement OTC credit market model in the first instance.
If we want to restore the Glass-Steagall separation between principal and agency activities, that is a reasonable public policy objective, but we need to accept that risk taking for own account is the chief area of capital allocation in most universal banks. The Volcker Rule's attempt to prohibit banks from engaging in principal investing activities is a nonsense in economic terms and bad public policy because all of the bank’s capital is now taken out of the risk markets. The Volcker Rule ignores the most basic and elementary facts about bank risk taking in the financial markets and must hurt overall liquidity among financial intermediaries and investors.
If we want to segregate customer activities from principal trading, that can be done but only if we go into the process fully aware of how banks take risk and support overall economic activity. The key failing of the Volcker Rule is that it attacks with operational constraints a problem that should be addressed via enforcement of a legal, professional and financial rules between these two important and necessary sides of the house. Front-running and other activities are illegal and we should enforce those rules. But if you understand that lending and investing take up the lion's share of the capital needs of any bank, then the convoluted half-measure which is the Volcker Rule of the Dodd-Frank law becomes truly ridiculous.