On October 11, the FDIC released proposed rules for implementing Section 619 of the Dodd-Frank Act—the so-called Volcker Rule. The next day, the SEC did the same. This is a joint effort of the FDIC, Federal Reserve Board, SEC and OCC. Their—largely identical—proposed rules are based on a 79 page study released by Tim Geithner’s Department of Treasury in January 2011.
The Volcker Rule was, of course, an attempt to restore some of the safeguards that were lost in 1999, when Congress scrapped the 1933 Glass–Steagall Act’s separation of commercial and investment banking. In its original form—as Paul Volcker first proposed it in early 2009—the Volcker Rule would:
- prohibit banks from engaging in proprietary trading, and
- prohibit them from investing their own capital in hedge funds or similar speculative funds.
The first item is the crux of the rule. The second is a safeguard to prevent banks from indirectly speculating through a hedge fund or other entity. Volcker explained the rule’s intent as:
We ought to have some very large institutions whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit. They ought to be the core of the credit and financial system. Those institutions should not engage in highly risky entrepreneurial activity.
[contentblock id=4 img=adsense.png]Barack Obama ignored Volckers proposal for a year, but with frustration over his coddling of Wall street near a boil, on January 21, 2010, he publicly endorsed it. He dubbed it the “Volcker Rule.” Congress incorporated a weakened version of the rule into the Dodd-Frank Act, allowing banks to invest up to 3% of their capital in hedge funds.
With Volcker unhappy about what happened to his rule, maybe we should rename it. One possible name would be “Zombie Glass-Steagall”. The rule doesn’t bring any of Glass-Steagall back to life. At best, it disturbs the grave of Glass-Steagall. It makes Glass-Steagall not alive, but undead. And the 298 pages of proposed regulations just released by the FDIC are an abomination—onerous, convoluted and riddled with loopholes.
[contentblock id=5 img=adsense.png]I have always opposed Zombie Glass-Steagall in any form because, fundamentally, it is flawed. While Glass-Steagall prohibited commercial banks from trading certain instruments, Zombie Glass-Steagall prohibits only the proprietary trading of those instruments. Proprietary trading can be indistinguishable from trading related to market making, hedging, underwriting, price discovery, liquidity management, asset-liability matching or a host of other practices. If a trader wants to disguise proprietary trading as one off these, believe me, he can.
Let me give you an example. It is called “trading around order flow”. Suppose a bank makes markets in certain bonds. They are negative on a particular bond, so, when a client places an order to buy that bond, they sell it without purchasing an offsetting position in the same bond. Selling the bond was “market making” but, by doing nothing at all, the bank now has a proprietary short position in the bond. The mere fact that the bank has that short position doesn’t make this proprietary trading. The bank will tell you that it is ineficient to hedge positions transaction-by-transaction—that they look at their portfolio overall and hedge its net exposures. Fair enough, but analyzing whether a trading book is hedged can be devilishly difficult. The trading book might have tens of thousands of positions in equities, bonds, derivatives, repos, you name it. Do you remember the debate over whether Goldman Sachs had shorted the mortgage market heading into the 2008 crisis? They smugly claim they were market neutral. How do you argue with something like that? It is all posturing.
The proposed rules that the FDIC and SEC just released envision banks implementing elaborate reporting and compliance systems to help senior executives and regulators spot proprietary trading. Banks will also have to calculate and track five categories of metrics:
- Risk-management measurements – VaR, Stress VaR, VaR Exceedance, Risk Factor Sensitivities, and Risk and Position Limits;
- Source-of-revenue measurements – Comprehensive Profit and Loss, Portfolio Profit and Loss, Fee Income and Expense, Spread Profit and Loss, and Comprehensive Profit and Loss Attribution;
- Revenues-relative-to-risk measurements – Volatility of Comprehensive Profit and Loss, Volatility of Portfolio Profit and Loss, Comprehensive Profit and Loss to Volatility Ratio, Portfolio Profit and Loss to Volatility Ratio, Unprofitable Trading Days based on Comprehensive Profit and Loss, Unprofitable Trading Days based on Portfolio Profit and Loss, Skewness of Portfolio Profit and Loss, and Kurtosis of Portfolio Profit and Loss;
- Customer-facing activity measurements – Inventory Turnover, Inventory Aging, and Customer-facing Trade Ratio; and
- Payment of fees, commissions, and spreads measurements – Pay-to-Receive Spread Ratio.
All this is staggeringly complex. Larger banks could spend millions of dollars a year complying with this mess. Smaller banks will receive exemptions from much of the reporting—Zombie Glass-Steagall isn’t intended for them.
What are regulators going to do with all the data they receive on the various metrics? No matter how much data there is, any determination on its meaning will be subjective. Regulatory agencies are under budgetary pressure, so it is not clear how they will afford additional enforcement. With Congress and the White House beholden to Wall Street, so are the heads of those regulatory agencies. How much career risk are their employees going to take to enforce Zombie Glass-Steagall? It isn’t going to happen.
What is really sad is the fact that the objectives of Zombie Glass-Steagall could easily be achieved by merely prohibiting banks from trading non-exempt instruments, as was the case under Glass-Steagall before it was repealed. That solution would be simple, inexpensive and objective. We didn’t need commercial banks trading mortgage-backed securities or credit default swaps prior to 1999. We don’t need them doing so now.
Don’t blame the FDIC, Federal Reserve Board, SEC or OCC for this mess. The regulators are doing the best they can with an impossible legislative mandate. It was Congress and the White House who imposed that mandate. Zombie Glass-Steagall will soon be stalking the land. Call your elective representatives and tell them to repeal the monster.