December 10 is shaping up to be D-Day for investment banks, the date on which the so-called Volcker Rule, one of the most contentious reforms proposed in the wake of the financial crisis, will finally come up for a vote by no fewer than five separate regulatory agencies.
The core idea behind the rule was to restrict banks from making speculative bets with their own money. That sounds simple enough, but the path from concept to code has been long and tortuous.
Already, banks have largely exited businesses that can be clearly labeled as hedge fund investing or proprietary trading. They dropped those activities well ahead of the implementation of the new rules (and, in the process, created an entirely new category of Wall Street professionals, the Volcker Rule refugees.) Now, the biggest question that remains is what else falls under the heading of “proprietary trading.” The final version of the rule isn’t yet public, but the one near-certainty is that it’s going to be a lot tougher on banks, making it more difficult for their trading desks to make money.
Banks and traders can get downright huffy when they’re challenged on just what is or isn't proprietary trading. That’s because, over time, it has become routine for trading desks to take positions on to their own books to help their clients.
Let’s say a Pimco or Blackrock fund manager wants to unload a giant block of stock in a company, all at once, and that the sale, if it all hit the exchange at the same time, would be triple or even quadruple the usual average daily trading volume. The fund managers — or their traders — will approach a firm like Goldman Sachs to act as an intermediary, taking the big block of stock onto their books and dribbling it out into the market on an opportunistic basis. Clearly, Goldman hopes to make a profit on the transaction, but its main reason for undertaking the transaction in the first place, it would argue, isn’t to make the profit but to help out its client.
In practice, distinguishing between proprietary trading and market making can be tricky. A lot of it is in the eyes of the beholder, too. That’s one reason why drafts of the Volcker Rule have contained exemptions allowing banks to keep making markets for their clients. The latest buzz, though, suggests that the final draft of the rule has significantly tightened the language surrounding the market-making exemption and others. Outgoing CFTC chair Gary Gensler and Kara Stein, a Democratic commissioner of the SEC, seem to have taken a particularly prominent role in the push to make the rule far more stringent for banks than original proposal, which had already aroused both ire and anxiety from financial institutions.
That said, Wall Street has played into the hands of Gensler, Stein and other critics in the last year or two. In particular, the “London Whale” debacle at JPMorgan Chase may have proved crucial to those pushing for the widest possible definition of “proprietary trading.” That $6.2 billion trading loss hit a bank that had survived the financial crisis with its reputation more or less intact and that was known for its risk management prowess.
On top of that, the trades that produced that gargantuan losses clearly fell into the gray area of the Volcker Rule. Were they proprietary trades or hedging activities? A subsequent investigation by a Senate panel came down squarely in the former camp, arguing that the bank cloaked its attempts to continue prop trading by describing it as hedging (another activity covered by a Volcker Rule exemption).
If regulators don’t draw a clear line and restrict hedging and market-making as much as possible, the argument goes, we’re more likely to see repeats of the London Whale losses as banks try to push the envelope. Those critics are right. Wall Street’s history — especially since large financial institutions became publicly traded corporations — is one of finding ways around loosely written rules and taking advantage of tiny gaps to undermine entire policies.
Just look at the history of the Depression-era Glass-Steagall Act that mandated the separation of commercial banks from investment banks. By the time it was eventually repealed in 1999, it had become as full of holes as Swiss cheese, thanks to decades’ worth of intensive efforts to undermine it on the part of both banks and regulators philosophically opposed to this structure. I know one securities lawyer who brags that his (substantial) personal net worth is due to his successful efforts to chip away at what in the early years of his career seemed like the solid mountain of Glass-Steagall.
No financial reform package will be perfect. The Volcker Rule as it gets implemented after it is finally approved by the SEC, CFTC, the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation is almost certainly going to have unintended consequences. It will put another big dent in Wall Street's revenues and profits from trading, and to the extent that trading liquidity diminishes, the banks will try to pin the blame on the new rules. After all, Morgan Stanley has already resorted to warning Americans that if the Volcker Rule goes through, it means that ordinary homeowners will pay higher heating and other utility bills, a rather melodramatic conclusion. (Other critics have suggested that we’ll all face higher fees on our checking accounts, too.)
The new rule will be no cure-all for Wall Street's ills. (Volcker himself has publicly expressed reservations about the measure.) It’s a rough and ready approach to excessive risk-taking, one that focuses on the nature of the hazard rather than on the magnitude or the ability of an institution to manage the risk.
As the London Whale events demonstrated, though, the historic strength of a financial institution when it comes to risk management may suddenly become irrelevant. While critics correctly point out that the crisis wasn’t caused by prop trading or investing in hedge funds, they fail to see that the root cause of many problems in the banking universe has been a steady drift away from the core business of serving as an intermediary. Banks have gone in quest of more profitable activities — of which prop trading is simply one. It can be redefined in such a way as to make it valuable to clients, too, but that’s not its raison d’etre. When such pursuits carry systemic risks, regulators have to step in.
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