Key Senators Sponsor Legislation Implementing Volcker Rules

Legislation banning bank proprietary trading and sponsoring of hedge funds has been introduced by key members of the Senate Banking Committee. The legislation would essentially codify the rules recently proposed by former Fed Chair Paul Volcker and endorsed by the Obama Administration. The Protect our Recovery through Oversight of Proprietary Trading Act (PROP Trading Act) was introduced by Senator Jeff Merkley and Carl Levin, Chair of the Investigations Subcommittee, and co-sponsored by Senator Sherrod Brown.

The measure would restrict these trades at banks and other large financial institutions. By keeping banks and other large, complex financial institutions away from these risky activities, the bill will help protect the taxpayer from bailouts and the damage to the economy that comes from the failure of critical financial institutions. At the same time, the bill leaves plenty of space for smaller firms to do speculative trading, but outside of taxpayer-supported commercial banks.

Specifically, the legislation would bar banks, bank holding companies, and their affiliates and subsidiaries from engaging in high risk speculation involving any stock, bond, commodity, derivative, or other security or financial instrument. It also requires large, important nonbank financial institutions to set aside additional capital to discourage them from engaging in high-risk speculation and investing or sponsoring hedge funds or private equity funds. The legislation also puts strict limits on the amount of such speculation.

The legislation would also reform certain aspects of the securitization process. It would prohibit securities brokers from betting against the packages of loans bundled into asset-backed securities that they are promoting to their clients. In addition, the PROP Trading Act would address fundamental conflicts of interest associated with the sale of loan-based asset-backed securities. Some financial firms put together and sold securities to their clients and then bet heavily against them. As some have noted, this is like building a car with no brakes, and then taking out life insurance on the purchasers. The PROP Trading Act would establish strong conflicts of interest protections to protect clients from these unfair and deceptive practices.

According to Senator Levin, the legislation is designed to prevent high-risk trading strategies adopted by a few firms from leading to another crisis. Senator Sherrod Brown, a co-sponsor of the bill, said that the legislation ends the conflict of interest situation under which investment firms packaged and sold toxic financial products and then used their own money to bet against these products.

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