Big Wall Street banks face an uneasy future after U.S. regulators on Tuesday finalized the Volcker Rule, a measure that attempts to curtail big bets on certain financial instruments. But in a potential concession, the banks themselves largely will be responsible for determining whether they're in compliance.
As Wall Street, Washington and the lawyers that advise them digested the rule, investors appeared to brush off concerns that the final version would dent banks’ profitability. Share prices of banks seen as most vulnerable to the rule rose.
Named after former Federal Reserve Chairman Paul Volcker, the idea began in 2010 as a simple effort to ban short-term speculative trading and investments in hedge and private equity funds by financial institutions that enjoy federal deposit insurance. Over the last few years, regulators had struggled to define what constituted speculation and what was merely the accumulation of financial instruments meant to be sold to clients, such as asset managers or other large investors.
More than 18,000 comment letters to the five federal agencies charged with developing the rule further clouded regulators’ efforts, and the rule became a symbol of whether the Obama administration and financial supervisors in Washington would rein in big banks or succumb to relentless industry pressure at a time when calls to break up the biggest banks appear to be growing.
Officials said the final rule attempts to straddle the line between banning so-called proprietary trading -- trading by banks for their own account -- but preserving big banks’ abilities to hedge their risks and buy and sell securities in order to serve their customers, otherwise known as market-making.
The rule promises unprecedented surveillance of big banks' trading operations, mostly through documentation requirements that force banks to justify trades and strategies and to keep running tallies of whether their activities conform to the rule.
But the establishment of parameters that ultimately will determine whether banks are complying with the rule was left to the banks themselves. The rule also relies on banks to tell regulators whether their trading practices, as they define them, comply with its provisions. Regulators largely will be responsible for double-checking the banks’ work.
“The rule is so conceptual it’s all about the implementation," said Marcus Stanley, policy director for Americans for Financial Reform, a group that represents more than 250 organizations. "The regulators didn’t draw really bright lines for hedging or market-making. This thing is one giant loophole if it’s badly implemented.”
Regulators largely missed the increasing risk in the financial system that preceded the 2008 crisis and the linkages between institutions that pushed many perilously close to failure when markets began to tank. They also failed to spot or reduce risk-taking at JPMorgan Chase in early 2012, when traders led by the so-called London Whale caused the bank to lose more than $6 billion on wrong-way bets.
“No one will really know whether regulators, who have failed so abysmally in the past, have learned from the crisis and will start regulating the banks for real by aggressively enforcing the Volcker Rule,” said Dennis Kelleher, president of Better Markets, a nonprofit group that advocates stringent rules on big banks.
Underscoring concerns that federal regulators largely outsourced the task of differentiating between proprietary trading and permitted activities, Sarah Bloom Raskin, the Federal Reserve governor President Barack Obama has nominated to be deputy treasury secretary, said that examiners from the agencies charged with enforcing the rule “will be leaned on heavily.”
“The proposed final rule has taken the approach of not setting explicit limits, but permitting regulated entities to set those limits through their compliance plans, and then monitoring those compliance plans,” Raskin said. “This emphasis on compliance within firm-chosen limits, rather than absolute thresholds, means that the role of supervisors and examiners and in particular the role of supervisor and examiner judgement and discretion become critical.”
Regulators ban trades that result in a bank’s exposure to “high risk” assets or trading strategies, but they declined to specify what constitutes “high risk,” Raskin noted. That further increases the importance of front-line examiners who would be charged with determining whether banks were violating the provision.
Raskin voted to finalize the proposal as President Barack Obama, Treasury Secretary Jack Lew and the heads of the Securities and Exchange Commission, the Fed, Commodity Futures Trading Commission, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corp. all praised the rule for generally making the financial system safer.
“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 firm’s practices,” Obama said.
Business and financial industry groups were more reserved, warning that the rule risks driving up costs for bank customers, investors and businesses that depend on banks for capital. The three Republican commissioners at the CFTC and SEC voted against the rule.
Regulators said the Volcker Rule was toughened in a few key areas from their 2011 proposal. It contains tighter language that now specifies that banks must link trades to specific risks they’re trying to mitigate -- rather than simply being allowed to claim that large batches of trades reduce their risk -- and a requirement that banks' board of directors and chief executives annually certify the effectiveness of their compliance regimes.
The provision requiring banks to specify risks they’re trying to hedge is largely a result of the London Whale episode, in which traders at JPMorgan Chase tried to reduce the bank’s exposure to certain hypothetical losses by taking on outsized risks in other categories that eventually cost the bank billions of dollars in losses and its reputation as a well-managed institution.
The CEO requirement was previously recommended in January 2011 by the Financial Stability Oversight Council, the Treasury Department-led group of financial regulators charged with protecting the U.S. economy from risks in the financial system.
In other ways, the final rule was relaxed from previous versions and earlier recommendations from FSOC were ignored.
For example, rather than solely allowing for banks to trade U.S. Treasuries and some municipal debt for their own short-term profit, regulators expanded the list of permitted securities to include all forms of municipal debt as well as obligations of foreign governments.
Regulators also expanded the list of funds exempt from restrictions that limited banks’ investments in them.
The FSOC recommendation that regulators require banks to measure the amount of trades initiated by their customers relative to trades they initiate on their own went ignored. Instead, regulators asked banks to measure the share of trades involving their customers compared with trading with other counterparties. But the final rule left open the possibility that banks may count other banks as their customers, casting doubt on the potential effectiveness of a measure intended to help determine whether banks are trading to benefit their own bottom lines or for the benefit of their clients.
Banks will have to collect data measuring seven key figures that ultimately will determine whether they’re complying with the Volcker Rule. The measurements begin next year. Banks won’t have to comply with the rule until 2015.
“For everybody -- regulators, advisers, consultants, lawyers and banks -- there is a learning curve with this rule,” said Robert Maxant, partner at Deloitte & Touche who leads the firm’s Volcker Rule efforts. “Once the regulators have metrics to compare across firms, and also examination experience, that comfort and understanding will grow.”
Maxant cautioned that regulators may be more likely to check for compliance only after banks experience big trading losses.
Raskin suggested that the approach favored by regulators may fall short, and that more intrusive oversight may be needed. For example, she said, although the rule specifies that bank employees can’t be paid in a way that encourages prohibited trading, regulators won’t know for sure by relying on banks’ own statements.
“It seems to me that if we’re serious about minimizing financial instability in the context of the Volcker Rule, then we have to engage in some scrutiny of the design of compensation plans and ask ourselves whether various pay arrangements are thwarting the rule’s goals by inducing traders and others to accept excessive levels of risk despite the existence of compliance plans, metrics and CEO attestations,” Raskin said.
Or, as Bart Chilton, a Democratic commissioner at the CFTC put it, regulators need to be “nimble and quick to ensure that what we do today holds up and that the high rollers' room isn’t reopened.”
Officials cautioned that while the rule would prevent another London Whale-type fiasco, it won’t stop what Jeremy Stein, Fed governor, described as “all future trading-related screwups.”
“It is important to keep in mind that the Volcker Rule is not a guarantee that firms we supervise won’t lose a lot of money in their trading operations," said Mark Van Der Weide, the Fed’s deputy director of bank supervision.
The rule doesn’t prevent banks from speculative long-term trading, nor does it limit short-term trading in loans, currencies or other assets beyond certain securities and derivatives, Van Der Weide said. It also exempts what he called “some of the most common forms of securities that banks trade in” -- namely U.S. Treasuries and securities and obligations of government-backed mortgage giants Fannie Mae and Freddie Mac.
In anticipation of the Volcker Rule, which became law in 2010 as part of the Dodd-Frank reforms, banks already have begun to shutter or rename their proprietary trading units and sell off their stakes in various hedge funds.
Kelleher said that one way in which the public can gauge whether the Volcker Rule is working as intended is to measure the number of traders leaving big banks, the decline in compensation for the traders that remain, and the fall in banks’ revenues from so-called FICC trading, which stands for fixed-income, currencies and commodities.
“This is not a perfect rule, but none are,” Kelleher said. “But make no mistake about it: regulators now own the Volcker Rule.
“They have to aggressively enforce it, ensure it is complied with or answer for any future blowups. Accountability on Wall Street and Washington is essential. If regulators fail again, then they must pay for that failure with their jobs.”