Monday, February 13, 2012

In Letter to SEC Former Fed Chair Volcker Defends Proposed Regulations Implementing Dodd-Frank Volcker Rule

In a letter to the SEC and banking agencies implementing the Volcker Rule provisions of the Dodd-Frank Act, former Fed Chair Paul Volcker emphasized that a basic public policy of Dodd-Frank is that proprietary trading of financial instruments, which is essentially speculative in nature, engaged in primarily for the benefit of limited groups of highly paid employees and of stockholders does not justify the taxpayer subsidy implicit in routine access to Federal Reserve credit or deposit insurance. Proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, he said, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens. Mr. Volcker also dismissed the argument that US banks complying with the regulations would suffer in their competitive position vis-à-vis international banks as ``superficial at best’’.

He also discussed what the former Fed Chair called the ``thorny issue’’ of guidance with respect to defining the character of market making for customers. Clearly, he posited, we know what it does not mean. Holding substantial securities in a trading book for an extended period obviously assumes the character of a proprietary position, he noted, particularly if not specifically hedged. Various arbitrage strategies, esoteric derivatives, and structured products will need particular attention, the central banker stressed, and to the extent that firms continue to engage in complex activities at the demand of customers, regulators may need complex tools to monitor them.

There may well be occasions when a customer oriented purchase and subsequent sale extending over days cannot be more quickly executed or hedged. But substantial holdings of that character should be relatively rare, he observed, and limited to less liquid markets. Flagrant, intentional violation of the general restrictions should be evident from review of well designed metrics and ad hoc examinations, he emphasized, and should also be identified by a bank’s internal controls.

Mr. Volcker’s understanding is that only a very few very large banking organizations engage in continuous market making on any significant scale. It is those institutions that will require the attention of the regulators. He also understands that the lawful restrictions extend to all banking organizations, including community and regional banks normally inactive. The management of those institutions must understand the nature of the restrictions.

However, consistent with effectively administering the law, oversight and reporting of those institutions may be less intrusive than that appropriate for active trading operations. For small banks, infrequent transactions with customers who may not have easy access to fluid public markets may at times lead to rather longer holding periods, subject to the review of the customer relationship and relevant record keeping. More generally, when or if there is demonstrably clear understanding and enforcement by management of the principles, detailed rules may be less necessary and oversight less intensive.

On the question of proprietary trading, the former Chair noted that it entails substantial risks. Securities are bought, held and sold in the expectation of profits from changes in market prices. The financial crisis has seen spectacular trading losses in large commercial and investment banks here and abroad operating on an international scale, with various loss estimates for major international commercial and investment banks ranging to hundreds of billions of dollars. Internal controls are difficult to implement in active and highly complex markets, he said, and in critical instances they proved woefully inadequate. Consequently, the stability of important banks was jeopardized, contributing to a financial crisis of historic dimension.

The need to restrict proprietary trading is not only a matter of the immediate market risks involved, in the central banker’s view, it is also the seemingly inevitable implication for the culture of the commercial banking institutions involved, manifested in the huge incentives to take risk inherent in the compensation practices for the traders. The result is to undermine the financial services industry as a service industry. Complicating the situation further are the unavoidable conflicts of interest inherent in proprietary trading, he added, particularly if embedded in market-making with the clear implication of fiduciary responsibilities toward customers. Institutional investors should be able to have confidence that their dealers are providing them the financial services they desire, for a transparent price, and are not operating at a conflict with their goals.

Mr. Volcker also assured that the restrictions on proprietary trading by commercial banks legislated by the Dodd-Frank Act are not likely to have an effect on liquidity inconsistent with the public interest. The trading in stocks is still dominated by organized exchanges, and it is not the main focus of commercial bank trading activity. Trading in fixed-income securities and derivatives has become an important part of the activity of a few commercial banks over the past decade.

Consequently, strong restrictions on proprietary trading and on sponsorship of hedge and equity funds under the new law present those institutions with a choice to either give up their proprietary trading activity or their banking license. The apparent reluctance to do the latter, he reasoned, only reinforces the perceived value of access to the Federal safety net and the substantial implicit subsidy to borrowing costs.

Proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, he said, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens. Today, thousands of hedge funds operating with relatively little leverage and dependent on the equity capital of partners, represent much more limited risk to the financial system in the event of failure.

Regarding competition, Mr. Volcker rejected the argument that United States banking organizations will suffer in their competitive position vis-à-vis international banks as ``superficial at best’’. Competition in banking, here as elsewhere, is desirable for the benefits it brings in institutional efficiency and better, more economical service to customers, he reasoned, and any contribution of proprietary trading to customer service and competition is not at all obvious.

Restrictions on proprietary trading offer customers a conflict of interest free platform, he pointed out, with bankers focused exclusively on their customer’s needs and with all of the bank’s capital committed in support of those customer activities. Both underwriting and market making could continue alongside non-bank financial institutions. Consequently, he concluded that U.S. banks will remain able to compete effectively for the full range of a customer’s financial needs, and stand strongly against institutions preoccupied with purely proprietary interests.

Deposit and payment facilities, the providing of credit, and asset management are the substance of commercial bank customer services. Does anyone really think that institutions with highly leveraged proprietary trading will lure this business from solidly capitalized, U.S. banks focused on serving customers, asked the former Fed Chair.