Thursday, May 10, 2012

Former Fed Chair Volcker Details Monitoring of Bank Proprietary Trading before Senate Panel; Discusses UK Ring Fencing

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.