Views on improving the integrity of global capital markets
18 January 2012

Volcker Rule: Let’s Make Paul Proud

I distinctly remember the carefree days of high school in the ‘70s. Absent were the college-admission pressures of today and the glareful eye of social networking sites. About the worst we had to contend with were unflattering nicknames that stuck in high school, only to resurface at every reunion thereafter. “Hey Tubby! Look everybody, it’s CC (Chubby Checker), and he’s lost weight!” 

While I digress somewhat, this brings me to the Volcker Rule and its namesake, former Fed Chairman Paul Volcker. What started as one man’s modest and well-meaning vision for regulatory reform — and separating the banks’ high-risk “proprietary” trading operations from their commercial ones — has turned into a complex mess. The question is whether Volcker will be proud or embarrassed having the rule nicknamed in his honor in the years to come.   

The original Volcker vision was actually quite simple and straightforward: eliminate, or otherwise segregate, the risks posed by proprietary trading from the large conglomerate banks that nearly toppled the financial system in 2008. The crisis and its fallout was a circumstance almost beyond imagining, and regulators and other industry stakeholders quickly set out to prevent a repeat. Whether prop trading was a direct cause or a catalyst for the crisis, Volcker wanted to ensure that a bank and its deposits are never at risk of collapse due to over-leveraged, highly speculative trading elsewhere in the banking organization. Unfortunately the resulting 300 pages of regulatory hieroglyphics that now pass for the rule proposal likely have its benefactor squirming at any association.

A lot is riding on the final outcome of the regulation. CFA Institute has been pouring over the proposal, meeting with industry experts, and conferring with our volunteer policy committees in an effort to decipher whether Volcker’s original intent is lodged somewhere in the expansive proposal. If so — and its density makes it hard to determine if it is — it is our goal to ensure such intent is codified as part of any final regulation. As you might expect, the rule is being heavily lobbied by a vast array of commercial interests. No surprise their focus is neither the investor nor systemic protection of the financial system.  

Here are some simple but key concepts that you may wish to consider and comment on. First, banks have several business lines that are typically organized as subsidiary operations. They include retail banking, investment banking, credit cards, asset management, brokerage, and proprietary trading (making trades with bank capital for company profit), among others.     

As Volcker suggested, eliminating that last item entirely from any connection to the bank or bank capital is already underway. Most of the largest firms have already done so, either shuttering or spinning off their proprietary activities. Assuming that is accomplished industrywide, attention then turns to the broker/dealer operations of the bank which engage in many of the same types of transactions previously done by proprietary trading operations. 

The remarkable similarity has many concerned that proprietary trading will simply shift over to, and become part of, the traditional market-making activities of the bank’s broker affiliate. In other words, activities portrayed as market making or hedging for customers could amount to a resumption of proprietary trading that exposes the banking system to risk.

Accordingly, we see three things as important to proper implementation of the Volcker Rule, as its namesake intended. First, any proprietary trading affiliate, backed by bank capital, must be eliminated from the banking firm. Second, market making by the bank’s brokerage affiliate should be permitted, but carefully monitored, to ensure it is not simply disguised proprietary trading. Finally, a full range of tools, strategies, and instruments should continue to be permitted as part of the market-making effort, consistent with liquid markets and facilitating efficient commercial financing practices. We all recognize the importance of robust and efficient commercial markets that do not otherwise imperil the safety and soundness of bank capital. If the rule fails on any of these fronts, it will leave the system at risk and diminish the original vision. This will leave both its namesake and investor protection advocates highly disappointed. 

What are your views? Join the commentary today on the proper scope and coverage of the so-called Volcker Rule proposal. Review the rule proposal for more information on how to submit a comment.

About the Author(s)
Kurt Schacht, JD, CFA

Kurt Schacht, JD, CFA, is managing director of the Standards and Financial Market Integrity division at CFA Institute, where he oversees all advocacy efforts and the development, maintenance, and promotion of the highest ethical standards of practice for the global investment management industry.

1 thought on “Volcker Rule: Let’s Make Paul Proud”

  1. pchepucavage says:

    The industry has made it seem almost impossible to distinguish prop trading from marketmaking.But we know they have to do that for their own risk analysis and bonus pay and they have done so in the past when required.The specialists were supposed to do it and today marketmakers must do so under reg sho.The rule can be simplified and the regulators can guide firms during the initial implementation.The Institute should support it without worrying that Wall Street will be offended and the regualtors should be selective in prosecuting initial mistakes.

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