Another conflict between market regulators and large institutional traders has flared up on Wall Street, as new trading regulations designed to hem-in the big banks’ risky trading practices were approved yesterday.
Although the Volcker Rule – named after Paul Volcker, former U.S. Federal Reserve Chairman and financial advisor to President Obama during the 2008 financial crisis – does not come into effect until July 21st, 2015, banks and institutional trading firms have already begun shutting down the departments that will be affected.
Lawmakers started working on the new rules in the wake of the financial crisis to ensure that taxpayers would never again be obliged to bail out banks for their risky trading practices. FDIC Vice Chairman Thomas Hoenig explained to USA Today that the rule’s objective is to force the largest banks to separate their proprietary trading businesses from client banking, and “away from the safety net” of government bailouts.
Yet what started as one short paragraph penned by Volker in 2009 has over four years grown into a 71-page rule requiring 850 pages of explanations that have divided banks from regulators on Wall Street and Republicans from Democrats in Congress.
While the Federal Reserve, the Federal Deposit Insurance Corp, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Office of the Comptroller of the Currency all gave their votes of approval Tuesday, banks and business interest groups vowed to appeal the rule in the courts. And it’s mostly based on three main areas of contention:
1. Limiting the Banks’ Speculative Trading
The proprietary trading portion of the rule aims to limit a bank’s investments in private equity, hedge funds, and commodity pools.
The U.S. Chamber of Commerce criticized the restriction, claiming it would hinder the growth of small and medium enterprises and slow job creation, as businesses would find it harder to raise capital. The Chamber is considering challenging the regulation in court, saying in a statement that it would “take all options into account as we decide how best to proceed.”
Yet the Volker Rule’s latest amendments have made some concessions in this area, allowing certain exemptions from the ban on private equity investments – such as joint ventures, funds that invest in asset-backed securities, wholly-owned subsidiaries of other companies, and when underwriting securities in certain new public offerings.
Perhaps sensing a losing battle ahead, several banks have already begun reducing their proprietary positions to bring them in line with the rule’s 3% invested capital limits, with Goldman Sachs (NYSE: GS) recently removing half a billion dollars from that arena.
2. Profiteering from Market-Making
The Volcker Rule also intends to clamp down on the big banks’ profiteering from their own clients’ trades, taking the opposite side of their customers’ buy or sell orders whenever there is room to make a profit for themselves. Yet this too is a highly debated restriction, since the banks really do provide a legitimate service to their clients when taking the opposite side of their trades.
Known as “market-making,” investment banks will build up an inventory of the more heavily traded stocks to ensure their clients always have a readily available supply of securities whenever they wish to trade them. Without the banks’ participation in the marketplace, many stocks’ bid-ask spreads would be much, much wider, resulting in investors paying too much when buying and receiving too little when selling. By being in the market at all times, market-makers provide liquidity and volume, helping to keep stock prices stable.
Still, there have been abuses, where investment banks would often trade “against” their clients instead of “with” them, swooping in to earn a trading profit off of their clients’ trades beyond their legitimate fees.
Juts how much extra profit were the banks making from this? Wall Street’s five largest firms were generating up to $44 billion in revenues from market-making, with JP Morgan (NYSE: JPM) earning the lion’s share of $11.4 billion. Although it is impossible to determine just how much of that came from profiteering against their clients’ trades.
Industry lobbyists and asset managers including Vanguard Group Inc. and Alliance Bernstein Holding LP warned that imposing too heavy a restriction on market-making could drain the marketplace of needed liquidity, resulting in increased volatility and unsettled markets.
The latest version of the Volcker Rule attempts to address that concern by loosening some of its restrictions on market-making – so long as banks execute both a buy and sell transaction and maintain both a long and short position in each security, thereby neutralizing any speculative betting in any one direction. The banks must also ensure their profit on a trade is based solely on commissions and the spread between their buying and selling prices, and does not include any profits that rightfully belong to their clients.
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3. Hedging Restrictions
The Volcker Rule also exacts stricter guidelines for hedging – when a long position in a security is counter-balanced by a short position in the same or related security.
Because the two legs that comprise a hedge move opposite each other, the risk inherent to the trade is reduced, if not completely neutralized. Hence, the margin or collateral required is greatly reduced, allowing the owner of the position to generate increased returns from dividends, interest, and sometimes capital gains using less invested capital.
But the definitions of what constitutes a true hedge have been very vague, allowing firms to call something hedged when it really contained much more risk than they were letting on. One notable example is the now infamous J.P. Morgan London Whale Trade of 2012 – so named for its sheer size and scope – in which the bank lost $6.2 billion on trades that had met the previous definitions of a hedge.
The new rule stipulates that banks must detail in writing precisely what risk a particular hedge is mitigating and how. Even JP Morgan president Jamie Dimon admitted to lawmakers last year that the new Volcker Rule changes to hedging definitions and requirements would have prevented last year’s losses from ever having happened.
“When people say this version of the Volcker rule will stop circumstances like the London Whale, this ongoing recalibration provision is exactly what will help avoid similar debacles,” CFTC Commissioner Bart Chilton endorsed the changes in a statement obtained by Bloomberg.
Battle Not Over
“This is definitely a step forward,” Bartlett Naylor, a financial policy advocate at Public Citizen, voiced his support for the Volcker Rule to the Associated Press. Yet he later acknowledged that putting the regulations into practice may require additional resolve. “It’s really up to (federal) supervisors to enforce it, and that’s a matter of choice.”
CLSA banking analyst Mike Mayo stressed his concern to USA Today that enforcing the new regulations is going to be extremely consuming. “I’ve done this (60 to 80) hours a week for 25 years, and even I have trouble getting my head around where proprietary trading begins and ends,” he cringes at the monumental task. It is now no longer a look at what traders are doing, but an examination of why they are doing it.
J.P. Morgan President Jamie Dimon mocked that they would have to post a psychologist and a lawyer next to every trader to ensure he wasn’t violating any rules. Volcker responded that enforcing the rule won’t be so monumental. “It’s like pornography,” Bloomberg quotes him. “You know it when you see it.”
Yet even if spotting violations are as simple as Volcker expects, enforcing them will be a different story. The enforcement task rests with the five regulatory agencies who approved the regulations yesterday, each with differing agendas – some being concerned about protecting the banks from future market risk and others more concerned about protecting the markets from bank-induced risk.
In the meantime, banks have already begun spending millions of dollars making changes to their operations. “We expect to see outlays for both information technology and staff,” Anthony Cimino, vice president for government affairs at the Financial Services Roundtable, said according to USA Today. “But it’s going to be difficult (to say how much) until we see the final rule.” This represents quite a risk to banking stocks as they shell out expenses in preparation for new rules that may easily end up changing several more times before taking effect in mid 2015.
“We are still reviewing the details of the final rule,” Democratic Senators Carl Levin and Jeff Merkley revealed in a joint statement. “But early indications suggest that persistence and common sense can prevail in the face of even the fiercest special interest lobbying campaigns: Hedging looks tougher, market-making looks simpler, trader compensation remains appropriately structured,” the Senators defended.
Many on Wall Street remain adamant that the new regulations are simply doomed to failure as they attempt to do more than isolate traders’ violations but also interpret their motives. Look for more debating over coming months, yet another uncertainty that could upset banking stocks in your portfolio.
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