In
testimony before a panel of the Senate Banking Committee, former Fed Chair Paul
Volcker said that the regulations implementing the bank proprietary ban imposed
by the Dodd-Frank Act should generally describe the characteristics of
proprietary trading, such as volatility; and that federal financial regulators
should examine the daily reports of the trading desks of financial institutions
to see if there are any characteristics suggesting proprietary trading. If
there are such characteristics, a closer examination is warranted. For example,
if the financial institution says a particular trade was for a customer, an
inquiry should be made as to the identity of the customer. The former Fed Chair
also noted that, in good faith, management, knowing that their reputation is at
stake with the regulator, will take due care.
Section
619 of the Dodd-Frank Act codifies the Volcker Rule and prohibits banking
entities from engaging in proprietary trading of any security, derivative, and
certain other financial instruments for the entity’s own account and owning,
sponsoring, or having certain relationships with a hedge fund or private equity
fund.
The
former Fed Chair said that efforts to harmonize the Volcker Rule
internationally have been impressive and that considerable progress has been
made. The UK is a particularly important jurisdiction in this regard, said the
former official, especially mentioning the recent proposals of the Vickers
Commission to ring-fence proprietary trading and relationships with hedge
funds.
The Vickers Commission recommended ring fencing retail traditional
banking activities from investment banking activities. While proprietary
trading and relationships with hedge funds would not be prohibited, these
activities would be outside the ring-fence and thus isolated from retail
banking where implicit government guarantees appear strongest. In addition, the
ring-fenced bank should be legally and operationally independent from the rest
of its corporate group. The UK
government has endorsed this recommendation.
Mr.
Volcker understands the concept of ring fencing as banning proprietary trading and
relationships hedge funds in a bank, but allowing such to be a separate part of
a holding company, divided by a wall. This is a different approach to the same
problem, he said, and one could argue that the UK approach is more rigorous. The UK approach puts hedge funds away from banks
with no contact, he noted, while the US allows a limited and controlled
relationship with hedge funds.
With
regard to the issue of too big to fail, the former Fed Chair said that the
Dodd-Frank Act provides a liquidation procedure (in Title II) under which a
failing financial institution will not be rescued, but rather will be
liquidated and the shareholders and management will be gone. But Mr. Volcker
did allow that the market is skeptical and believes that the US government will come to the
rescue of a failing firm and, despite Title II, will not allow a large
financial institution to be liquidated. While the former Fed Chair believes
that this skepticism is overdone, it is real and must be dealt with. There are
also international complications, he added, since a large financial institution
is very likely to have non-US operations.