Regulators Finally Approve Volcker Rule Trading Ban: Lawyers Rejoice

Christmas came early to lawyers, who spent most of yesterday peeling off the elaborate wrapping (700 pages of preamble) of the long-anticipated Volcker Rule intended to limit U.S. banks’ proprietary trading activities. It probably wasn’t exactly what Paul Volcker had in mind four years ago when he suggested that banks that enjoyed federal deposit insurance not stray far from traditional commercial banking activities, but here we are after 2,000 pages of Dodd-Frank, 17,000-plus comment letters on the first attempt at a proposed rule, and the collective input of five Washington regulatory agencies.

Any lessons learned from Dodd-Frank about quantity’s inferiority versus quality of regulation haven’t informed this effort. Common wisdom has it that having activated massive lobbying efforts to shape the rule that was issued, the banks will now press their legal armies to devise compliance strategies or fight implementation of the rule outright. For our friends in the legal profession, this is indeed the gift that keeps giving.

Investors should be far less certain of celebration, for they have multiple interests at stake, not all of which align perfectly. For example, investors might take some cheer from the rule’s provisions that banks no longer link employee compensation to trading profits, thereby addressing a conflict of interest that reared its ugly head in episodes like the Abacus deals. It is a bit mystifying why the buy-side needed to wait for regulations to “fix” this issue rather than imposing the power of the market and diverting its business away from banks that were less than ideal partners. But a sort of investor Stockholm syndrome seems to have taken hold these past years instead. Now investors need not wonder how their sales and trading desk contacts will fare personally from the trade being urged upon them.

Systemic Risk Mitigation and Market Liquidity of Concern

Investors also have interests in financial stability and mitigation of systemic risks. One of the goals of the Volcker Rule is to limit the moral hazard associated with risk-taking activities at federally insured institutions, and in particular, its aim is to limit the risks that accumulate in potentially “too-big-to-fail” banks through proprietary trading and investments in opaque vehicles like hedge funds and private equity.

The irony is that banks are being encouraged to lend rather than trade and invest. But lending is a fairly opaque and high-risk activity in its own right. Moreover, it isn’t grounded in fair value reporting the way that trading activities are. In fact, there’s a pretty compelling case too that it was lending, and not trading, that created the force behind the 2008 financial crisis.

So while the Volcker Rule addresses some systemic risk issues of interest to investors, they aren’t necessarily the issues that are most relevant to our most recent crisis. Further, as some of the activities that are restricted by the Volcker Rule migrate to the shadows of the financial system, systemic risk monitoring and mitigation will become more difficult.

Investors also should have concerns over the consequences of banks being encouraged to scale down business lines in which they act as principals. This is especially true in fixed-income markets, where banks have been an essential feature, offering liquidity through the power of their balance sheets. Although market-making is preserved under the Volcker Rule, it comes with some significant compliance burdens that require banks to demonstrate that principal activities relate to historical customer demands. At the least, increased compliance expense will be passed on to customers. New providers of liquidity might be more decentralized and opaque, which doesn’t bode well for favorable pricing for investors. Investors who factor in lower liquidity will raise the cost of borrowing, creating a headwind in already challenging economic times for businesses raising capital. And any rise in rates could have negative effects on bank balance sheets, bloated as they have become with low-yielding assets originated in years of QE.

Can Regulators Effectively Monitor Mega-Bank Risk?

With the regulatory community being invited to look over the shoulder of bank risk management activities, officials at the Federal Reserve and Office of the Comptroller of the Currency should be setting aside time and resources to bring examination staff up to speed on the complexities of managing mega-bank risks before implementation in 2014. Although bank examiners aren’t at the mercy of Congressional appropriations committees for their funding, it is fair to wonder how effective they will be relative to the wealth of resources deployed on the other side of the conference room table. Investors might view with some caution regulators’ ability to monitor and assess risk and hedges in time to make a difference, but their efforts are worthwhile and necessary.

For now, lawyers and policy geeks alike are wading through the rule’s text. Look for decisions soon from banks intent on challenging the fundamental premise of the regulation through the courts. Failing success on that front, compliance strategy is poised to become even more prominent as a focus of bank executives. Investors should hope for compliance grounded in the intent to divorce risk unrelated to traditional banking. But they should examine bank returns for components derived from stretching every possible loophole, and consider the sustainability of such a compliance strategy and the ongoing risks implied in doing “business-more-or-less-as-usual.”

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