Free Market Will Trump Volcker Rule In End

The WealthCycles Staff

The ink was still wet on U.S. President Barack Obama’s signature signing the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in July 2010 when the wrangling began over how and how much to clamp down on trading by federally insured banks. Even though the financial reform act was passed, the devil is in the details of how regulators will actually implement it.

The Volcker Rule, named for the former Federal Reserve chairman, was inserted into the Dodd-Frank Act to prohibit federally insured banks from gambling with depositor funds, incurring losses that would have to be covered by the Federal Deposit Insurance Corporation. But Congress, deluged with protests from Wall Street, didn’t want to cut off banks’ ability to trade entirely. Some trading by banks, such as buying up certain kinds of securities to resell to bank customers or investing bank-owned funds to help hedge against future losses, is considered legitimate and desirable to keep the financial markets running smoothly. When you’re dealing with millions and billions, sorting out which type of trade is which is immensely complex. Given too much laxity in the rules, banks could find creative ways of getting round them. And with five federal agencies— the Federal Reserve, Securities and Exchange Commission, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency—involved in the rulemaking, too many cooks are sure to ruin the soup.

Initially scheduled to take effect with the Dodd-Frank Act in July 2012, complaints from Wall Street and hesitancy from the regulatory agencies has stalled implementation of the Volcker Rule. President Obama is pushing the agencies to get the final draft in place by end of year. But as the New York Times reported this week, “Even at this late stage, the Volcker Rule is a work in progress.”

While the agencies have reached a broad agreement on most issues, a new version of the draft is being circulated among regulators nearly every day, officials say. The draft, with all its varied edits, spans about a thousand pages. And agencies might ultimately split off and vote separately.

The New York Times report provides one example of the “fuzzy” boundaries between different types of trades and the difficulty of delineating between them. Buying securities that a bank’s client might want to buy is an example of a trade that would be allowed, known as “market making.”

[Gary] Gensler, [head of the Commodity Futures Trading Commission], officials briefed on the negotiations said, wants to insert language that would tighten the market making definition. In the real world of Wall Street, traders at a bank might keep buying shares of Apple until they have a substantial position in the company.
On the surface, that might look like market making, since clients have in the past wanted to buy Apple shares. But the bank may have actually amassed the position because it thinks the shares will rise in the future, effectively making it a speculative proprietary position. To prevent that sort of maneuver, Mr. Gensler’s agency is pushing to limit the ability of banks to stockpile such large positions.

Meanwhile the proposed rule has raised a rash of objections from foreign governments given that the rule, when finally implemented, will be applied to foreign banks operating in the U.S., The Financial Times reports. The outcry seems ironic given that international financial authorities are making similar moves to separate out proprietary banking and consolidate them under central control. (See our WealthCycles article for more on this.)

Even Paul Volcker must be shaking his head at the convoluted process for implementing what was intended to be a fairly simple rule: don’t gamble with the customers’ money. History predicts that after all the red-faced huffing and puffing dies down and a rule, however imperfect, is put into place, only then will we begin to realize the unintended consequences that will result. So-called financial reform, despite good intentions, is just another manifestation of government interference in the free markets. In the end, the market always has its way.

Matt Levine: Eliminating the words “portfolio hedging” is not the same as eliminating portfolio hedging. The rule allows hedges “designed to reduce or otherwise significantly mitigate … one or more identifiable risks,” as long as they don’t create “any significant new or additional risk that is not itself hedged contemporaneously.” So it is not entirely clear to me from that that the rule forbids “portfolio hedging”.

If it does, it's the pin prick we awaited -- will the Fed get to grant extensions to "Volker" compliance individually, per previous rule iterations?