May 30, 2015    6 minute read

Is Wall Street Ready for the Volcker Rule?

   May 30, 2015    6 minute read

Is Wall Street Ready for the Volcker Rule?

The Dodd-Frank Reform Act and Consumer Protection Act was signed into federal law by President Barack Obama in July 2010. Passed as a response to the subprime mortgage crises and the following economic and financial crisis, the implementations were the most significant changes to financial regulation in the United States since the regulatory reform that followed the Great Depression of 1939. The stated aim of the legislation is:

An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes

The Dodd-Frank Act

There is an on going debate regarding the effectivity of the regulation and the nature of its implementation. There are indeed many critics, namely Republicans and ‘Wall Streeters’ who still wish to kill the Act. Additionally, the complexity of the regulation has resulted in discussions in the hundreds of meetings that banking regulators have had with industry groups to iron out any complexities on both sides of the table, with requests for subtle changes in the rule-making process and redefinitions of financial instruments, as a means to loosen the vice of complexity.

The bigger issue of the battle between Dodd-Frank’s supporters and opponents is an uncertainty in regards to the exact operations of investment banks and levels of risk taken, especially when they are economically ‘too big to fail.’ Ex-Lehman Chief Richard S. Fuld Jr. took the brunt of the ramifications of such after Lehman filed for bankruptcy and stated:

“Hi, I’m Dick Fuld, the most hated man in America”

More recently however, Fuld gave his first public remarks since testifying to Congress in 2008 about Lehman’s collapse and discussed the “perfect storm” that led to the financial crisis. The speech demonstrated some “unspoken” truths about the bankruptcy of Lehman; “Lehman Brothers was not at the edge of the liquidation in September 2008” but still demonstrated the opacity of such banks and has questioned the effectiveness of the Dodd-Frank Act.

The Volcker Rule

Dodd-Frank is a sweeping regulatory initiative and there is no reason to believe that Congress got it perfect the first time around. It did not. But it is equally unrealistic to equate any small attempt to improve it as a wholesale assault on the desirable goal of avoiding a future financial crisis. Even today, five years after its settlement, Dodd-Frank is still an amorphous beast. However, one thing is clear: It does little to prevent the rent-seeking and regulatory arbitrages that have become the hallmarks of the 21st century bank. In many ways, the financial world that Fuld left behind seems somewhat of a distant memory, with the 2010 Dodd-Frank financial reform legislation designed to keep firms like Lehman from ever having a systemic effect on the world economy. Viral Acharya, a finance professor at New York University recently stated:

“Wall Street has changed…The incentives, and the ability, to leverage through the regulatory cracks, that ability has been shrunk dramatically, however imperfect Dodd-Frank might be”

A major legislative item within the Dodd-Frank framework that will be implemented in July 2015 is the Volcker Rule. The rule prevents US banks (and international banks with US operations) from short-term prop trading for the banks’ own books, as well as prohibiting them from having general trading relationships with hedge funds and private-equity funds.

Customer deposits, which previously could have been previously used for prop trading, are now clearly separated from such activity. Trades related to risk-reducing hedges, market making, underwriting and liquidity management would be exempt from Volcker to ensure that market liquidity, among other considerations, remains unaffected.

From a front-office perspective, the Office of the Comptroller of the Currency last year calculated that in order for US banks to solely have trades on their books that are given the green light by Volcker, they could lose up to $4.3 billion from having to unwind all “unrestricted” investments at a loss.

The Investment Banks

The reaction from within investment banks has been one of grave concern, with many feeling that the industry is now over-regulated. In March of this year, the Federal Reserve Board conducted its annual stress tests on US banks in an effort to verify whether a specific lender had enough cash and robust internal risk-management systems in case of an economic disaster. This year, the Fed found no problems with 28 of the 31 BHCs tested.

This indicates a sequential improvement in the capital strength of the country’s largest banking groups. Notably, Bank of America (which received a conditional approval) will have to resubmit its capital plan by the end of the third quarter after addressing several deficiencies in its capital planning process as identified by the Fed. The Fed observed that there were:

“Weaknesses in certain aspects of Bank of America’s loss and revenue modelling practices and in some aspects of the BHC’s internal controls”

The Fed also mentions that Goldman Sachs, J.P.Morgan and Morgan Stanley were required to resubmit their capital plans before they got their approval, as their original capital plans saw at least one of their post-stress test capital ratios fell short of regulatory requirements.

The FX Scandal

In mid-May, six banks were fined $5.6bn over rigging of foreign exchange markets – another blow to the already tarnished banking sector.

Source: FT

Source: FT

The revelation that traders colluded to manipulate currency exchange rates was particularly embarrassing for the banks because it occurred after they had paid billions of dollars to settle claims that their traders had tried to rig interbank lending rates. It has raised questions as to whether the industry had gleamed any lessons from the previous scandal, and whether regulation was indeed stringent enough.

Some could say that the bite is worse than the bark in terms of the incoming regulatory implementations as it poses a threat to investment banks, especially as more is on the way. It seems particularly clear that the new culture of tighter regulation, stricter compliance and more robust risk-management is here to stay. Therefore, it is indeed the case of how quickly can such institutions adhere to the requirements, enabling them to realign their focus back to one of growth and profitability, rather than one of contingency and cost minimisation.

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