Volcker vs. Vickers (Part 1) — Which Plan Is Best for Banks?

Between British economist Sir John Vickers — who in 2010 became chair of the U.K.’s newly created Independent Commission on Banking — and former Federal Reserve Chair Paul Volcker, there few people as synonymous with efforts to prevent another systemic meltdown as these two policy luminaries.

As we approach the five-year mark since the global financial crisis’ peak in 2008, a recent event in New York featured Volcker and Vickers discussing the lingering fallout of the financial crisis and still-nascent reform efforts. The discussion was noteworthy for both the stature of the commentators as well as their distinctly different approaches to systemic-risk-based regulation.

A range of topics were on the agenda — beginning with the lack of reform progress and what is needed to advance the effort. In covering the differences between the Vickers and Volcker approaches to reform, the discussion covered the “financial weapons of mass destruction” label ascribed to the vast OTC derivatives market and, most importantly to these two titans, the reform efforts to address both structural and regulatory weaknesses concerning large, complex financial institutions, or the “Too-Big-to-Fail” conundrum. This is the first in a month-long series exploring several of the topics discussed.

Comparing the Two “V”s

As a starting point, a high-level comparison of the Volcker and Vickers regulatory-reform approaches is useful. It lays the foundation for many of the key questions investors should be asking — not the least of which is whether we’re satisfied, or at least optimistic, that we are making progress in the fight to prevent another major financial crisis. Truth be told, neither Vickers nor Volcker is particularly content with the state of reforms. As public taxpayers forming the backstop for financial transgressions, we should be even more concerned.

The Volcker Approach

A high-level overview of the Volcker approach generally centers around the notion of prohibiting the high-risk activities of proprietary trading. This is where the banking institution trades and speculates on various investments for its own account. Essentially the bank is acting like an investment fund or hedge fund, trying to goose bank revenues and profits by making highly speculative, short-term trades.

The obvious concern is that, in the process of engaging in this type of activity, it puts insured deposits — and potentially the very existence of the bank — at risk. Whatever the combination of reasons for the demise of Wachovia and Washington Mutual, along with other well-known megabanks needing vast capital backstops from the government to weather the ensuing financial market turmoil in 2008-2009, the prop-trading portfolio can no longer be one of them according to the Volcker Rule. Another aspect of Volker’s approach is the requirement to divest and refrain from creating and sponsoring private equity or hedge fund products within an insured depository institution or the bank holding company for such institution.

In both cases, the Volcker approach is a regulatory method to limit riskier behaviors and business activities within a government-insured institution. Currently, the vast majority of regulatory details and enactment of related rules for implementing the so-called “Volcker Rule” are in flux. Perhaps most daunting to achieving a workable Volcker Rule are the very real complexities of giving a bank leeway to still engage in trading that looks nearly identical to proprietary trading but done in the context of investment banking, market-making (brokerage), or hedging the bank’s own exposures. A recent event at JPMorgan — in which it engaged in complex credit default swap transactions in the name of hedging, only to lead to significant unknown or unexpected risk exposure to the depository institution — is a useful and timely example. The difficulty in calibrating rules on what is proper hedging versus a veiled continuation of proprietary trading is formidable. Meanwhile, actual implementation of any proprietary-trading rules is subject to a transition period that now stretches through the summer of 2014, and can be extended for up to three additional years beyond that.

The Vickers Approach

A high-level overview of the Vickers philosophy is an interesting contrast to the regulatory approach of restricting the speculative activities of proprietary trading by regulation. Vickers seeks to create a structural change to the manner and nature of how U.K. banks actually operate. The key focus of this change is to legally separate or “ring fence” the retail banking operations of U.K.-based banks from other business activities common to such banks, including global trading, investment banking, and brokerage services. Similar to the Volcker approach, this structural change is aimed at removing any connection with riskier, nontraditional banking activities that potentially place the depository institution in jeopardy.

Similar to the Volcker motivation, the specific concern is to wall off insured deposits and ensure survival of the traditional bank by protecting it from major risk factors revealed in the financial crisis. Lead among them: the build-up of risky assets and extensive interconnections with global counterparties that can put the bank capital structure under great stress and expose it to systemic instability — a perfect storm that can cause precipitous runs on banks, hindering their ability to meet liabilities and service retail customers.

It should also be noted that, unlike Volcker, the Vickers effort attempts to address the complex area of bank capital requirements. It seeks the imposition of significant increases in capital requirements for U.K.-domiciled banks, over and above the capital requirements proposed under Basel III. No doubt the complexity and politics of setting satisfactory capital reserve rules will elevate the scrum between industry lobbyists and regulators to a whole new level. Meanwhile, the actual implementation of the Vickers-related reforms is targeted for 2015, with a further fallback date for ring fencing by 2019, potentially a full 10 years post-crisis.

Next week: Have we squandered an opportunity to learn lessons from the financial crisis? We’ll examine the current state of reform.

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