The Volcker
rule, approved by US regulators this week, aims to rein in risky trading
practices at US banks. Some consider it the biggest milestone in financial
regulation since 1933, some say it's worse than nothing.
The Volcker
rule - named after former Federal Reserve Chairman Paul Volcker - is a key
plank of the Dodd-Frank financial regulation law that was passed in 2010 in
response to the global financial crisis of 2008. It was approved after two
years of debate and lobbying by the big banks to modify it.
"The
Volcker rule will make it illegal for firms to use government-insured money to
make speculative bets that threaten the entire financial system, and demand a
new era of accountability from CEOs, who must sign off on their firms'
practices," US President Barack Obama said after the rule was approved by
five US regulatory agencies, including the Federal Reserve and the Securities
and Exchange Commission (SEC) on Tuesday (10.12.2013).
In essence,
the rule severely limits so-called proprietary - or prop - trading, where banks
trade for their own profit. US banks are required to put in place compliance
programs and document trades to demonstrate that they are in a client's
interest or a hedge against risk, rather than purely for profit.
 |
Paul Volcker is a former chairman
of the Federal Reserve |
Profound or
inept?
"There
hasn't been a change this big in the banking industry since 1933," says
Mark Williams, a former Fed bank examiner who now teaches at Boston University
and has written extensively on the collapse of Lehman Brothers.
"The
onus has been pushed back on banks to demonstrate that they are not in
violation…through good record-keeping, analysis, through back-testing. They
have to demonstrate that they are using risk-management best practices in their
hedging operations."
But critics
say it is unworkable, as it will be hard to distinguish between mere gambling
and legitimate trades.
"It
won't work because it will be too easy to evade," Bill Black, also a
former regulator, who now teaches at the University of Missouri-Kansas City,
told DW.
Apart from
being far too much work for understaffed regulatory agencies, he says, "as
soon as you tell the banks they can hedge, against a trillion and a half
dollars worth of their portfolio, tell me you couldn't find something that that
would be a hedge for."
"It's
a tragic lost opportunity for real reform," Black told DW. "It is
worse than nothing," he says.
Back to
banking basics?
Many
experts consider proprietary trading to be one of the reasons for the 2008
crisis, in particular the rise of a specific type of prop trading, so-called
mortgage-backed securities, "manufactured by some of the largest banks…,
sold by them and kept in their portfolios," Williams told DW. These
securities often involved repackaged subprime mortgages that led to mass
foreclosures, when people could not pay their loans off.
Working in
banking now is a far cry from the 1980s when "being a banker used to be a
"respected, but also a very boring profession," Williamson says.
"The
traditional banking model was a two-legged stool - banks earned income through
loans and through fee services, like asset management."
To make
more money "the very large banks brought a third leg to that stool and
that was prop trading…and that leg is being knocked out and it's going to be a
tough transitional period for many of these large banks."
And,
indeed, the American Bankers' Association (ABA) argues in a statement on their
website that, apart from being "burdensome and highly complex," the
rule will lead to "decreased liquidity and inferior product pricing"
for customers.
The banks
were hoping that the Volcker rule would be much less stringent, but a
6.2-billion dollar trading loss by JPMorgan Chase in the UK in 2012 - known as
the "London Whale" - gave the Volcker implementation process the
"momentum," Williams says, to curb proprietary trading in a more
substantial way.
 |
The London Whale debacle cost JPMorgan
Chase over 6 billion dollars, plus fines |
JPMorgan
Chase, he says, "was a hedge fund disguised as an FDIC- [federally - the
ed.] insured commercial bank."
"There's
going to be much less profit to be made from that third leg," he says,
arguing that the London Whale loss, and more importantly, the fact that the
trader hid the true extent of the losses from management, could have been
prevented had the Volcker rule been in place.
Still too
big to fail
Bill Black
is among those who are calling for much tougher measures, such as cutting banks
down to size to eliminate the "too big to fail" argument that he
believes encourages risky behavior.
Because of
the feared domino effect of one of the big banks failing and dragging the whole
economy down with it, "too big to fail institutions - the systemically
dangerous institutions - can borrow much more cheaply, which creates a huge
competitive advantage," he told DW.
Borrowing,
especially short-term borrowing, grew rapidly in the run-up to the 2008 crisis,
says Benn Steil, senior fellow at the Council on Foreign Relations in a
memorandum. So, an approach to reform "that restricts the scope and
incentives for bank balance-sheet expansion funded by short-term debt is
essential to prevent another crisis." The Volcker rule will do nothing of
the sort, he argues.
Glass-Steagall
to the rescue?
Black goes
a step further by insisting that the Glass-Steagall Act from 1932/33 should be
reinstated. It was part of the US Banking Act passed in the wake of the Great
Depression. It separated traditional banking from riskier activities like
investment banking. It was repealed in 1999, allowing practices like
proprietary trading to emerge.
"It
[Glass-Steagall] worked brilliantly for 50 years and was praised by almost
everybody," Black told DW. But "we violated one of the key rules of
life - if it's not broke, don't fix it," he said.
Black says
it is not just the US that has so far failed to pass meaningful regulation.
"Contrast the boldness of the US response to the Great Depression and the
successful boldness in regulation with the timidity of the global response to
the current crisis, where we feel that we can't even think boldly."
The Volcker
rule will come into effect on April 1, 2014, but banks have been given until
mid-2015 to fully comply.
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