Thursday, February 16, 2012 4:03:37 AM
Volcker Rule Will Raise Risk, Costs for U.S. Financial System, Critics Say
By Cheyenne Hopkins and Silla Brush - Feb 13, 2012 12:40 PM CT
Representatives for the world’s largest banks said a U.S. proposal to ban proprietary trading would increase risk, raise costs for investors and be vulnerable to legal challenge.
Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co. and Bank of America Corp. (BAC), alongside foreign banks and governments, were set to file letters today in opposition to the Volcker rule, a proposal made under the 2010 Dodd-Frank Act that seeks to limit risky trading at banks that receive federal assistance.
“The proposal will severely limit banking entities’ ability to hedge their own risk, thereby increasing rather than decreasing the risk to banking entities and the financial system,” the Clearing House Association, American Bankers Association, Securities Industry and Financial Markets Association, and Financial Services Roundtable said in joint 173-page letter.
The rule named for former Fed Chairman Paul Volcker, who championed it as an adviser to President Barack Obama, would seek to ban banks from proprietary trading while allowing them to continue short-term trades for hedging or market-making. It also would limit banks’ investments in private-equity and hedge funds.
The proposal is one of the most contentious provisions of Dodd-Frank, the regulatory overhaul enacted in 2010 that requires the ban on proprietary trading to be in place by July 21. A 298-page proposal released by U.S. regulators in October included more than 1,300 questions for affected banks to consider during the comment period, which closes today.
Volcker Speaks
Volcker himself weighed in to defend his namesake rule [ http://www.sec.gov/comments/s7-41-11/s74111-182.pdf (last item below)], arguing the proposal is “not at all likely” to have an effect on liquidity and that bankers’ arguments that U.S. competitiveness would suffer are “superficial at best.”
“Losses within large trading positions were in fact a contributing factor for some of our most systemically important institutions, and proprietary trading is not an essential commercial bank service that justifies taxpayer support,” Volcker wrote.
Series of Exemptions
The proposal included a series of exemptions for permissible market-making trading, underwriting and hedging transactions. Lawmakers exempted market-making from the rule, along with certain forms of hedging and underwriting, because of concerns that a broad ban on proprietary trading could bring some U.S. and world markets to a halt.
SIFMA, which represents large financial institutions including Goldman Sachs, Bank of America, and Blackrock, argued in its letter that rule, as proposed, wouldn’t pass judicial scrutiny in part because regulators have “fallen far short” of conducting a cost-benefit analysis.
In their letter, the bank lobbying associations said the cost-benefit analysis in the Volcker rule didn’t meet the standards set in a court case overturning a Securities and Exchange Commission rule last year. The letter referenced the Business Roundtable’s victory against the SEC, which overturned the so-called proxy access rule designed to let shareholders put their own candidates on corporate ballots. The U.S. Court of Appeals in Washington agreed with the U.S. Chamber of Commerce and Business Roundtable.
Higher Fees
Banks that make markets may pass on higher fees to their investors if the rule restricts their revenue from holding large, or block, positions as inventory, according to Janet McGinness, senior vice president at NYSE Euronext.
“In facilitating the ability of the customer to quickly sell such a large block of stock, the market maker may hold in inventory that portion of the purchase shares that it cannot resell without driving down the price of the stock,” McGinness said in a letter to regulators. The proposal may lead traders to set higher fees because of restrictions on how long inventory can be held, she said.
Douglas Sheline, senior vice president and assistant treasurer of M&T Bank Corp. (MTB), said the proposed rule would impose a harsh burden on regional banks. Banks like his would be required to “develop and implement, in extremely short order, compliance, internal controls, record keeping and reporting regimes simply to ‘prove a negative’ -- that we are not engaged in impermissible proprietary trading,” Sheline said in a letter. The Volcker threshold for banks with average trading assets could be raised from the current $1 billion to $5 billion or higher and still capture “at least 98% of total average trading assets and over 97% of total trading liabilities.”
Small Business
The U.S. Chamber of Commerce argued that the proposed rule would restrict credit for small businesses or result in higher costs for basic financing. “Small businesses will have to forgo business opportunities altogether due to the increased capital costs and diminished access” to credit, David Hirschmann, president and CEO of the Chamber of Commerce, wrote in a letter.
Foreign banks and governments also are fighting the rule for its extraterritorial reach. While non-U.S. government bonds would fall under the rule as proposed, U.S. government debt would be exempt.
Officials from Canada, Japan, the United Kingdom, and the European Banking Federation have sent letters to the U.S. Treasury Department and other regulators saying the measure would harm global liquidity and international cooperation. G-20 leaders have not endorsed the rule.
Overseas Reach
Regulators should “limit the scope of the rule only to the territory of the United States,” European Union Financial- Services Commissioner Michel Barnier said in a letter to regulators. “Moreover, the current exemption for non-U.S. banks as well as for activities outside of the U.S. would appear very restrictive.”
Six Canadian bankers and the Canadian government said the Volcker rule’s inclusion of Canadian securities in the proprietary trading ban would violate the North American Free Trade Agreement that guarantees that banks be allowed to trade equally in both U.S. and Canadian debt obligations.
“Failure to exclude Canadian public funds will undermine years of cooperation between U.S. and Canadian regulators as demonstrated by NAFTA provisions and by efforts to carefully adapt the U.S. securities laws to the realities of the growing economic and business integration of Canada and the United States,” wrote the Bank of Montreal, the Bank of Nova Scotia, Canadian Imperial Bank of Canada, Royal Bank of Canada and the Toronto-Dominion Bank. (TD)
To contact the reporters on this story: Cheyenne Hopkins in Washington at chopkins19@bloomberg.net; Silla Brush in Washington at sbrush@bloomberg.net
To contact the editor responsible for this story: Maura Reynolds at mreynolds34@bloomberg.net
©2012 BLOOMBERG L.P.
http://www.bloomberg.com/news/2012-02-13/volcker-rule-will-raise-risk-costs-for-u-s-financial-system-critics-say.html
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At Volcker Rule Deadline, a Strong Pushback From Wall St.
Randall Guynn, left, Margaret E. Tahyar and Gabriel Rosenberg at Davis Polk, which handled Volcker Rule work.
Michael Falco for The New York Times
By BEN PROTESS and PETER EAVIS
February 13, 2012, 8:41 pm
Wall Street made its broadest assault yet against new regulation on Monday, taking aim at a rule that has come to define the battle over how to police banks in the aftermath of the financial crisis.
Regulators in charge of writing the Volcker Rule [ http://topics.nytimes.com/top/reference/timestopics/subjects/v/volcker_rule/index.html ], which would ban banks from trading with their own money, were inundated with complaints and suggestions [ http://www.sec.gov/comments/s7-41-11/s74111.shtml ] on Monday, the deadline to comment on a draft proposal. More than 200 letters were expected to be filed by the midnight deadline on the rule, which regulators outlined in October.
Commenters included the rule’s namesake, Paul A. Volcker [ http://topics.nytimes.com/top/reference/timestopics/people/v/paul_a_volcker/index.html ], the former Federal Reserve chairman, who submitted a strongly worded defense of the rule’s intent in a letter [ http://www.sec.gov/comments/s7-41-11/s74111-182.pdf (last item below)] on Monday. Others, like consumer advocates and lawmakers, criticized the draft rule for not being tough enough.
Senators Carl Levin [ http://topics.nytimes.com/top/reference/timestopics/people/l/carl_levin/index.html ] of Michigan and Jeff Merkley [ http://topics.nytimes.com/top/reference/timestopics/people/m/jeff_merkley/index.html ] of Oregon, both Democrats, led the effort to insert the Volcker Rule in the Dodd-Frank act, the sweeping regulatory overhaul passed in response to the financial crisis. In a comment letter on Monday, the senators said the proposed rule was “too tepid.”
But the loudest response came from critics like Wall Street trade groups and banks, who want to soften the rule. The rule, the critics said, is a threat to the health of the financial industry and the broader economy.
“This will make the overall economy less stable and less conducive to growth,” David Hirschmann, head of the Center for Capital Markets Competitiveness at the Chamber of Commerce, said in a letter.
The pushback against the Volcker Rule is the latest effort under way on Wall Street to mute the impact of Dodd-Frank. But the campaign against the Volcker Rule is more pronounced than banks’ earlier attempts to temper new regulations for lending and derivatives.
Wall Street firms, lawyers and trade groups churned out many Volcker Rule appeals. The Securities Industry and Financial Markets Association, or Sifma, hired the law firm Davis Polk to write multiple pitches to regulators. A hodgepodge of Wall Street trade groups led by Sifma alone filed five comment letters on Monday, including one document that spanned 173 pages. A regulatory comment letter normally runs 10 to 20 pages. During the writing period, most big banks formed internal Volcker Rule “task forces,” often led by risk officers and lawyers, to coordinate the effort across trading desks and divisions, people briefed on the efforts said.
The letter writing went right down to the deadline. Over the weekend, a dozen or so lawyers huddled on the 17 floor of Davis Polk’s Midtown Manhattan headquarters, making final changes to more than 10 letters written on behalf of banks and Sifma.
“I’ve never seen a rule-making response like this before,” said Derek M. Bush, a partner at the law firm Cleary Gottlieb who helped write comment letters for banks and financial industry groups.
Wall Street’s biggest banks even submitted their own comment letters, taking an unusually aggressive stance that underscored the importance of the issue. Ordinarily, banks prefer to have trade groups and lobbyists do the talking for them.
But with profits — and the future model of the industry — at stake, Goldman Sachs [ http://dealbook.on.nytimes.com/public/overview?symbol=GS ], Morgan Stanley [ http://dealbook.on.nytimes.com/public/overview?symbol=MS ] and Citigroup [ http://dealbook.on.nytimes.com/public/overview?symbol=C ] each submitted a comment letter, people briefed on the matter said. The letters were not yet public, but they were expected to be filed before the midnight deadline.
“Firms usually feel that it’s best to work only with the trade group letter,” said Margaret E. Tahyar, a partner at Davis Polk who worked on several Volcker Rule comment letters. “But the Volcker Rule is such a major shift, that many, many firms felt they needed to also write letters in their own name.”
Banks have held meetings with regulators to spell out their case. Goldman officials have met six times [ http://www.sec.gov/comments/s7-41-11/s74111.shtml#meetings ] with the Securities and Exchange Commission [ http://topics.nytimes.com/top/reference/timestopics/organizations/s/securities_and_exchange_commission/index.html ] over the last three months.
The insurance industry also injected itself into the debate, arguing that regulators need not apply the Volcker Rule to their business, according to people briefed on the matter.
The scope of the Wall Street pushback reflects the complexity of the rule. The draft rule that regulators unveiled last October spans about 300 pages and poses some 1,300 questions for the public to address.
Now, the comment deadline ushers in a critical phase. Equipped with arguments from every side, regulators will turn their focus to completing details of the rule.
Still, it could take months for the five regulators — the Federal Reserve, the S.E.C., the Federal Deposit Insurance Corporation [ http://topics.nytimes.com/top/reference/timestopics/organizations/f/federal_deposit_insurance_corp/index.html ], the Commodity Futures Trading Commission [ http://topics.nytimes.com/top/reference/timestopics/organizations/c/commodity_futures_trading_commission/index.html ] and the Office of the Comptroller of the Currency [ http://topics.nytimes.com/top/reference/timestopics/organizations/c/comptroller_of_the_currency/index.html ] — to sift through the hundreds of comment letters. Financial industry lawyers have already forecast that regulators will miss the July deadline to put the rule into effect.
Wall Street, sensing opportunity in a delay, urged regulators to take their time. Some letters suggested that the regulators “repropose” the rule, or scrap the earlier proposal altogether and start from scratch.
Supporters of the Volcker Rule say that is a ploy to delay it until after the 2012 election, which may end the Democratic control of the Senate and the White House.
“It’s part of their ongoing strategy — if you can’t kill the rule, you may as well delay it as long as possible,” said Dennis Kelleher, president of Better Markets, a nonprofit group that advocates stricter financial regulation [ http://topics.nytimes.com/topics/reference/timestopics/subjects/c/credit_crisis/financial_regulatory_reform/index.html ].
The Volcker Rule aims to ban banks from placing bets with their own money, a practice known as proprietary trading. The rule is based on the belief that banks that enjoy government backing — like deposit insurance — should not be able to trade in this way.
Much of the debate over the Volcker Rule will center on defining what amounts to proprietary trading. The line can be blurred between proprietary trading and legitimate market-making, a practice in which banks hold securities with the intent of selling them to a customer. Regulators have acknowledged that deciphering that gray area is difficult.
The chief critics of the Volcker Rule have seized on the imprecision, saying that securities markets rely on banks holding large inventories of bonds so that investors can buy and sell them easily. The rule’s attempts to distinguish between trading and market-making “would have significant deleterious real-world effects on financial markets and on the investors and customers that rely on such markets for liquidity,” Sifma wrote in its comment letter.
But holding large amounts of securities has hurt banks. During the financial crisis, banks suffered huge losses on assets that were originally intended for clients, like the mortgage securities that meant big losses for Citigroup and Merrill Lynch [ http://topics.nytimes.com/top/news/business/companies/merrill_lynch_and_company/index.html ]. And banks’ inventories of financial assets ballooned in the years leading up to the financial crisis, leaving them particularly vulnerable to losses when customer demand for the assets dried up.
The rule’s supporters argue that banks are defining market making so broadly that it could include some forms of risky proprietary trading. “Holding substantial securities in a trading book for an extended period obviously assumes the character of a proprietary position, particularly if not specifically hedged,” Mr. Volcker wrote in his comment letter.
Or, as Mr. Kelleher put it, “Calling something market making doesn’t make it so.”
Copyright 2012 The New York Times Company
http://dealbook.nytimes.com/2012/02/13/at-volcker-rule-deadline-a-strong-pushback-from-wall-st/ [with comments]
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Paul Volcker: Here Are 5 Ways To Know Prop Trading When You See It
Ben Walsh
February 13, 2012
Today, Paul Volcker [ http://www.businessinsider.com/blackboard/paul-volcker ] sent [ http://www.businessinsider.com/volcker-tells-his-haters-to-back-off-2012-2 ] his much anticipated letter [ http://www.sec.gov/comments/s7-41-11/s74111-182.pdf (last item below)] to regulators concerning the eponymous rule he championed restricting proprietary trading, along with an accompanying essay.
The premise of the rule is notoriously simple: proprietary trading is not an essential financial service and should not be allowed at institutions that have any form of explicit or implicit government support.
But how do you implement it?
Sure, there's out and out prop trading, which most banks who will be subject to the rule have by now jettisoned.
But what about the gray areas like market making, banks say? That's a vital function we provide and the Volcker rule shouldn't prohibit it. We have to buy and sell securities in anticipation of client demand, use our own capital to facilitate their trade views, etc., etc.
Well, Paul Volcker had heard the banks. And he's put the ball back in their court.
In his letter, he puts forward five metrics that both individually and in concert can be used to establish if a bank is violating the rule.
Oh, but first say Volcker, banks will need attentive CEOs, watchful boards of directors, robust control and reporting systems and above all a culture that 'puts clients first.'
But since there isn't a bank in the country that would publicly say it doesn't have any one of these things, let's move to the five metrics Volcker outlines in his letter:
1. "trading volume, and its relation to size of the trading 'book'"
2. "the volatility of earnings from trading"
3. "the extent to which those earnings are generated by pricing spreads rather than changes in price"
4. "the origination of trades (i.e. from customer initiative)"
5. "the close alignment of 'hedging' transactions with the composition of the trading positions"
The thrust of each of these metrics is that Volcker thinks it should be incumbent on banks to show that they're not using market making activities to engage in proprietary position taking. No single one of these metrics would in isolation demonstrate that a particular trade or desk or division or institution is or isn't prop trading.
But taken as a whole, they do get at many of the issues banks have raised with the rule.
Are banks holding a bunch of inventory on their books in the hope that it will rise in value, irrespective of whether they are even trading it that much? That doesn't sound like market making. See #1.
Do earnings from trading rise and fall dramatically from quarter to quarter? Market making in really liquid markets should a fairly steady, boring earnings generator. If not, see #2.
Is an institution making money on margin (spread) or asset value swings? The latter could be argued to be prop trading, with the customer used as a handy fall guy to exit a position. See #3.
Are banks doing a ton of trading but not really serving clients? Or are banks doing very little trading despite high volumes of client inquiry? In either case, see #4.
When does a hedge cease to be a hedge and become a proprietary position in and of itself? Re-watch the Goldman hearings chaired by Carl Levin. Actually, the answer is when the hedge is no longer connected to a risk embedded in a position and becomes a view on the price of securities in and of itself. See #5.
Volcker's message to banks: your serve.
Copyright © 2012 Business Insider, Inc. (emphasis in original)
http://articles.businessinsider.com/2012-02-13/wall_street/31054155_1_proprietary-trading-volcker-rule-banks [with comment]
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Sen. Levin Grills Goldman Sachs Exec On "Shitty Deal" E-mail
Senator Carl Levin (D-MI) and former Goldman Sachs Mortgages Department head Daniel Sparks, Senate Governmental Affairs Subcommittee on Investigations hearing, April 27, 2010
http://www.youtube.com/watch?v=gLx2Xc1EXLg
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Senate Hearing: Sen. Levin vs. Lloyd Blankfein, Goldman Sachs
http://www.thesoapboxroadshow.com/ WASHINGTON - Concluding a two-year bipartisan investigation, Senator Carl Levin, D-Mich., and Senator Tom Coburn M.D., R-Okla., Chairman and Ranking Republican on the Senate Permanent Subcommittee on Investigations, today released a 635-page final report (PDF, 6MB) on their inquiry into key causes of the financial crisis. The report catalogs conflicts of interest, heedless risk-taking and failures of federal oversight that helped push the country into the deepest recession since the Great Depression.
http://levin.senate.gov/imo/media/doc/supporting/2011/PSI_WallStreetCrisis_041311.pdf
http://www.youtube.com/watch?v=oOpFbjHcxF0
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February 13, 2012
DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Part 44 Docket No. OCC-2011-0014 RIN: 1557-AD44
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 12 CFR Part 248 Docket No. R-1432 RIN: 7100-AD82
FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 351 RIN: 3064-AD85
SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 255 Release No. 34-65545; File No. S7-41-11 RIN: 3235-AL07
COMMODITY FUTURES TRADING COMMISSION 17 CFR Part 75 RIN: 3038-AD05
Subject: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds.
This letter sets out my comments on your proposed rules implementing the portion of the Dodd-Frank legislation restricting proprietary trading and investment in hedge and equity funds by U.S. banking organizations. I have attached a more lengthy statement reviewing the policy considerations compelling the legislation and dealing with concerns about the impact on markets and competition, points that are sometimes lost amid the intense lobbying efforts on detailed implementation.
I cannot help but be impressed by the success the regulatory agencies so far in reaching agreement on the preliminary rule and by your confidence that the regulation can and will be successfully implemented. I am also certain that simplicity and clarity are challenging objectives, which for full success, require constructive participation by the banking industry. As I have suggested elsewhere, there should be a common interest in an approach that, to the extent feasible, is consistent with the banks’ broader internal controls and reporting systems.
My sense is that success is strongly dependent on achieving a full understanding by the most senior members of the bank’s management, certainly including the CEO, and the Board of Directors, of the philosophy and purpose of the regulation. As the rules become effective, periodic review by the relevant supervisor with the Boards and top management will certainly be appropriate, as a key part of the usual examinations process or otherwise.
The necessary understanding should be reflected in both the culture of the bank and in the written internal controls applicable to trading activities and to relations with hedge and equity funds that have an element of bank sponsorship and investment. Obviously, those controls must be consistent with the specifics of the regulation restricting proprietary trading.
At the other end of the process is the need for a set of “metrics” designed to reveal evidence of deliberately concealed and recurring proprietary trading. I know much effort has been made in that area. While I am not familiar with all the details, I do emphasize its importance.
I understand that such measures as trading volume, and its relation to size of the trading “book”, the volatility of earnings from trading, the extent to which those earnings are generated by pricing spreads rather than changes in price, the origination of trades (i.e. from customer initiative) and the close alignment of “hedging” transactions with the composition of the trading positions will be essential tools for supervisors and management to monitor the trading activities of firms.
To the degree those metrics can be made consistent with the banks’ internal reporting and control systems, both management control and simplicity will be greatly facilitated.
I realize that between those two requirements – management commitment and ex-post measurement of performance – lies the thorny issue of guidance with respect to defining the character of “market making” for customers. Clearly, 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, particularly if not specifically hedged. Various arbitrage strategies, esoteric derivatives, and structured products will need particular attention, 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, 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 (and should, of course, also be identified by a bank’s internal controls).
My understanding is that only a very few very large banking organizations engage in continuous “market making” on any significant scale. Clearly, it is those institutions that will require the attention of the regulatory authorities. I also understand that the lawful restrictions do 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 time 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.
I need not add that I continue to follow with interest your efforts to assure meaningful and effective execution of the law and fidelity to the important considerations of public policy that the law is intended to enforce.
[signed]
Paul A. Volcker
*
COMMENTARY ON THE RESTRICTIONS ON PROPRIETARY TRADING BY
INSURED DEPOSITARY INSTITUTIONS
By Paul A. Volcker
Full discussion by the public, and particularly by directly affected institutions, on the proposed regulations implementing the Dodd-Frank Act, as with all proposed rules, is necessary and important. It is also true that the commentary and debate may generate uncertainty and confusion along with useful and needed improvements. That has been apparent in responses to the proposed regulation implementing certain restrictions on proprietary trading by commercial banking organizations – the so-called “Volcker Rule”.
In sorting out the problems – the real from the imaginary, the truly important from the incidental – the basic logic and approach of the law deserves re-emphasis.
The basic public policy set out by the Dodd-Frank legislation is clear: the continuing explicit and implicit support by the Federal government of commercial banking organizations can be justified only to the extent those institutions provide essential financial services. A stable and efficient payments mechanism, a safe depository for liquid assets, and the provision of credit to individuals, governments and business (particularly small and medium-sized businesses) clearly fall within that range of necessary services. Proprietary trading of financial instruments – 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, deposit insurance or emergency support.
In fact, the comfort for creditors and others inherent in the ability of institutions engaged in proprietary trading to resort to the Federal “safety net” can only tend to encourage greater leverage and risk-taking. Commercial bank proprietary trading is thus at odds with the basic objectives of financial reforms: to reduce excessive risk, to reinforce prudential supervision, and to assure the continuity of essential services.
The questions and objections raised in comments on the proposed rules appear to fall into four broad categories:
1. Proprietary trading by commercial banks is not an important risk factor;
2. Needed liquidity in trading markets will be imperiled;
3. The competitive position of U.S. based commercial banking institutions will be adversely affected;
4. The proposed regulation is simply too complicated and costly.
My short answer to each of these objections is: “not so”. I will comment on each of them in turn.
THE RISK
On its face, proprietary trading entails substantial risks. It is essentially speculative in nature: securities are bought, held and sold in the expectation of profits from changes in market prices. The recent years of financial crisis have 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.
Demonstrably, internal controls are difficult to establish and to implement in active and highly complex markets. In critical instances they proved woefully inadequate. Consequently, the stability of important banks was jeopardized, contributing to a financial crisis of historic dimension.
The pressures on the big, American investment banks actively engaged in proprietary trading were the leading case in point. They required substantial government (i.e., taxpayer) assistance both before and more dramatically after the Lehman bankruptcy. Either directly or by merger with a commercial bank, the largest investment banks acquired a banking license, in effect being accorded the comfort of access to massive Federal Reserve and FDIC assistance.
To be sure, there were many factors other than proprietary trading contributing to the breakdown of financial markets. The speculative “bubble” in housing prices and the subsequent declines, excessive leverage by banks and other institutions (including the overuse and abuse of derivatives), inadequacies in accounting practices, and certainly the lack of regulatory oversight all contributed. Many of the losses within the thinly capitalized commercial banking system simply reflected weak underwriting practices. In that sense, proprietary trading, and the related activity of sponsorship and investment in hedge and equity funds, were not alone in causing the crisis. Many factors were involved. However, losses within large trading positions were in fact a contributing factor for some of our most systemically important institutions, and proprietary trading is not an essential commercial bank service that justifies taxpayer support.
The need to restrict proprietary trading is not only, or perhaps most importantly, a matter of the immediate market risks involved. It is 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. Can one group of employees be so richly rewarded, the traders, for essentially speculative, impersonal, short-term trading activities while professional commercial bankers providing essential commercial banking services to customers, and properly imbued with fiduciary values, be confined to a much more modest structure of compensation?
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, 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.
LIQUIDITY
As a general matter, efficient markets do need arrangements to facilitate trading in financial instruments. That ability to buy and sell large volumes of assets on short notice (termed “liquidity”1) appeared, prior to the crisis, to be greatly enhanced. There should not, however, be a presumption that evermore market liquidity brings a public benefit.
At some point, great liquidity, or the perception of it, may itself encourage more speculative trading, even in longer-term instruments. Presumably conservative institutional investors are tempted to turn over positions much more rapidly, at the expense of careful analysis of basic values.
In the light of events, careful consideration of the benefits and possibly damaging consequences of increased liquidity has become the subject of new studies and commentary by economists and regulators. A consensus may be developing that beyond some point, little or no public benefit may be evident2.
In any event, the restrictions on proprietary trading by commercial banks legislated by the Dodd-Frank Act are not at all 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: give up either their proprietary trading activity or their banking license. The apparent reluctance to do the latter only reinforces the perceived value of access to the Federal safety net and the substantial implicit subsidy to borrowing costs.
In essence, proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens. That, in essence, was the de facto distinction maintained until the last decade or two. 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.
COMPETITION
The argument that United States banking organizations will suffer in their competitive position vis-à-vis international banks seems superficial at best, and more likely proprietary trading is counter to their prospects. Competition in banking, here as elsewhere, is desirable for the benefits it brings in institutional efficiency and better, more economical service to customers. Any contribution of proprietary trading to customer service and competition is not at all obvious. In fact, because of the risks, the conflicts of interest and the adverse cultural influence it may well impede effective competition.
Deposit and payment facilities, the providing of credit, and asset management – these 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?
Restrictions on proprietary trading offer customers a “conflict of interest” free platform, 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 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.
COMPLEXITY
The complexity and potential costs of any rule-making in the world of modern finance presents a challenge. Enforcement of the restrictions required by the Volcker Rule is no exception. In approaching this problem, let us not lose sight of the fact that existing risk management practices of large financial institutions here and abroad, including some major
U.S. commercial banks, fundamentally failed, at great cost to financial stability and the world economy. Hopefully, lessons have been learned. Both regulators and the regulated have been compelled to review previous practices, including various “metrics” to measure risk and to specifically control trading activity.
The regulators have released a “first draft”. They have provided ample opportunity for comment. As in other areas, judgments must be made about the balance between detailed
rules and a more principle-based approach – conceptualized as “Trust but Verify”3. Proprietary trading in any real volume is confined to a very few large, sophisticated U.S. banks: it has been reported that only six banks account for almost 93 percent of the trading revenue of all American banks. Purely proprietary activity is likely to have been even more concentrated.
CONCLUDING COMMENTS
In all their complexity, our giant banks are not easy institutions to manage. They need active leadership, an alert Board of Directors, internal controls, and even more a strong cultural tradition of “the customer comes first”. By their nature, they also have both large resources and a reservoir of management and technical talent.
The Federal regulators have enormous challenges of their own. They have also had a great learning experience, and have been tested beyond memory. Writing effective regulations to carry out all of the Dodd-Frank Act requires the best talent the regulating agencies have. And, at the end of the day, I feel confident that the restrictions imposed by the “Volcker Rule” can be reasonably and effectively administered.
With active cooperation among the agencies and with constructive consultation instead of futile stonewalling, an important reform can soon be put in place.
1 In most contexts, “liquidity” is defined as financial instruments thatare inherently safe, short-term, and readily turned into cash with littlerisk of loss (i.e., Treasury Bills). “Market liquidity”, defined as theease of trading any financial (or even non-financial) instrument, is moreintangible, and depends upon the particular circumstances.
2 See, for instance, lectures by Lord Adair Turner, Chairman of the U.K.Financial Services Agency entitled “What Do Banks Do, What Should They Do,And What Public Policies Are Needed To Ensure Best Results For The Real Economy”, 17 March 2010 and “Economics, Conventional Wisdom And PublicPolicy”, April 2010. Much earlier, in 1989, Lawrence and Victoria Summerswrote a prescient analysis, warning against excessive liquidity,concluding that the need for a Transaction Tax should be explored. In the1930’s, John Maynard Keynes also questioned excessive emphasis onliquidity.
3 I deal with these matters in my comment letter more fully.
*
http://www.sec.gov/comments/s7-41-11/s74111-182.pdf
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(linked in):
http://investorshub.advfn.com/boards/read_msg.aspx?message_id=67558486 and http://investorshub.advfn.com/boards/read_msg.aspx?message_id=67817175 and http://investorshub.advfn.com/boards/read_msg.aspx?message_id=67902071 and preceding and following
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By Cheyenne Hopkins and Silla Brush - Feb 13, 2012 12:40 PM CT
Representatives for the world’s largest banks said a U.S. proposal to ban proprietary trading would increase risk, raise costs for investors and be vulnerable to legal challenge.
Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co. and Bank of America Corp. (BAC), alongside foreign banks and governments, were set to file letters today in opposition to the Volcker rule, a proposal made under the 2010 Dodd-Frank Act that seeks to limit risky trading at banks that receive federal assistance.
“The proposal will severely limit banking entities’ ability to hedge their own risk, thereby increasing rather than decreasing the risk to banking entities and the financial system,” the Clearing House Association, American Bankers Association, Securities Industry and Financial Markets Association, and Financial Services Roundtable said in joint 173-page letter.
The rule named for former Fed Chairman Paul Volcker, who championed it as an adviser to President Barack Obama, would seek to ban banks from proprietary trading while allowing them to continue short-term trades for hedging or market-making. It also would limit banks’ investments in private-equity and hedge funds.
The proposal is one of the most contentious provisions of Dodd-Frank, the regulatory overhaul enacted in 2010 that requires the ban on proprietary trading to be in place by July 21. A 298-page proposal released by U.S. regulators in October included more than 1,300 questions for affected banks to consider during the comment period, which closes today.
Volcker Speaks
Volcker himself weighed in to defend his namesake rule [ http://www.sec.gov/comments/s7-41-11/s74111-182.pdf (last item below)], arguing the proposal is “not at all likely” to have an effect on liquidity and that bankers’ arguments that U.S. competitiveness would suffer are “superficial at best.”
“Losses within large trading positions were in fact a contributing factor for some of our most systemically important institutions, and proprietary trading is not an essential commercial bank service that justifies taxpayer support,” Volcker wrote.
Series of Exemptions
The proposal included a series of exemptions for permissible market-making trading, underwriting and hedging transactions. Lawmakers exempted market-making from the rule, along with certain forms of hedging and underwriting, because of concerns that a broad ban on proprietary trading could bring some U.S. and world markets to a halt.
SIFMA, which represents large financial institutions including Goldman Sachs, Bank of America, and Blackrock, argued in its letter that rule, as proposed, wouldn’t pass judicial scrutiny in part because regulators have “fallen far short” of conducting a cost-benefit analysis.
In their letter, the bank lobbying associations said the cost-benefit analysis in the Volcker rule didn’t meet the standards set in a court case overturning a Securities and Exchange Commission rule last year. The letter referenced the Business Roundtable’s victory against the SEC, which overturned the so-called proxy access rule designed to let shareholders put their own candidates on corporate ballots. The U.S. Court of Appeals in Washington agreed with the U.S. Chamber of Commerce and Business Roundtable.
Higher Fees
Banks that make markets may pass on higher fees to their investors if the rule restricts their revenue from holding large, or block, positions as inventory, according to Janet McGinness, senior vice president at NYSE Euronext.
“In facilitating the ability of the customer to quickly sell such a large block of stock, the market maker may hold in inventory that portion of the purchase shares that it cannot resell without driving down the price of the stock,” McGinness said in a letter to regulators. The proposal may lead traders to set higher fees because of restrictions on how long inventory can be held, she said.
Douglas Sheline, senior vice president and assistant treasurer of M&T Bank Corp. (MTB), said the proposed rule would impose a harsh burden on regional banks. Banks like his would be required to “develop and implement, in extremely short order, compliance, internal controls, record keeping and reporting regimes simply to ‘prove a negative’ -- that we are not engaged in impermissible proprietary trading,” Sheline said in a letter. The Volcker threshold for banks with average trading assets could be raised from the current $1 billion to $5 billion or higher and still capture “at least 98% of total average trading assets and over 97% of total trading liabilities.”
Small Business
The U.S. Chamber of Commerce argued that the proposed rule would restrict credit for small businesses or result in higher costs for basic financing. “Small businesses will have to forgo business opportunities altogether due to the increased capital costs and diminished access” to credit, David Hirschmann, president and CEO of the Chamber of Commerce, wrote in a letter.
Foreign banks and governments also are fighting the rule for its extraterritorial reach. While non-U.S. government bonds would fall under the rule as proposed, U.S. government debt would be exempt.
Officials from Canada, Japan, the United Kingdom, and the European Banking Federation have sent letters to the U.S. Treasury Department and other regulators saying the measure would harm global liquidity and international cooperation. G-20 leaders have not endorsed the rule.
Overseas Reach
Regulators should “limit the scope of the rule only to the territory of the United States,” European Union Financial- Services Commissioner Michel Barnier said in a letter to regulators. “Moreover, the current exemption for non-U.S. banks as well as for activities outside of the U.S. would appear very restrictive.”
Six Canadian bankers and the Canadian government said the Volcker rule’s inclusion of Canadian securities in the proprietary trading ban would violate the North American Free Trade Agreement that guarantees that banks be allowed to trade equally in both U.S. and Canadian debt obligations.
“Failure to exclude Canadian public funds will undermine years of cooperation between U.S. and Canadian regulators as demonstrated by NAFTA provisions and by efforts to carefully adapt the U.S. securities laws to the realities of the growing economic and business integration of Canada and the United States,” wrote the Bank of Montreal, the Bank of Nova Scotia, Canadian Imperial Bank of Canada, Royal Bank of Canada and the Toronto-Dominion Bank. (TD)
To contact the reporters on this story: Cheyenne Hopkins in Washington at chopkins19@bloomberg.net; Silla Brush in Washington at sbrush@bloomberg.net
To contact the editor responsible for this story: Maura Reynolds at mreynolds34@bloomberg.net
©2012 BLOOMBERG L.P.
http://www.bloomberg.com/news/2012-02-13/volcker-rule-will-raise-risk-costs-for-u-s-financial-system-critics-say.html
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At Volcker Rule Deadline, a Strong Pushback From Wall St.
Randall Guynn, left, Margaret E. Tahyar and Gabriel Rosenberg at Davis Polk, which handled Volcker Rule work.
Michael Falco for The New York Times
By BEN PROTESS and PETER EAVIS
February 13, 2012, 8:41 pm
Wall Street made its broadest assault yet against new regulation on Monday, taking aim at a rule that has come to define the battle over how to police banks in the aftermath of the financial crisis.
Regulators in charge of writing the Volcker Rule [ http://topics.nytimes.com/top/reference/timestopics/subjects/v/volcker_rule/index.html ], which would ban banks from trading with their own money, were inundated with complaints and suggestions [ http://www.sec.gov/comments/s7-41-11/s74111.shtml ] on Monday, the deadline to comment on a draft proposal. More than 200 letters were expected to be filed by the midnight deadline on the rule, which regulators outlined in October.
Commenters included the rule’s namesake, Paul A. Volcker [ http://topics.nytimes.com/top/reference/timestopics/people/v/paul_a_volcker/index.html ], the former Federal Reserve chairman, who submitted a strongly worded defense of the rule’s intent in a letter [ http://www.sec.gov/comments/s7-41-11/s74111-182.pdf (last item below)] on Monday. Others, like consumer advocates and lawmakers, criticized the draft rule for not being tough enough.
Senators Carl Levin [ http://topics.nytimes.com/top/reference/timestopics/people/l/carl_levin/index.html ] of Michigan and Jeff Merkley [ http://topics.nytimes.com/top/reference/timestopics/people/m/jeff_merkley/index.html ] of Oregon, both Democrats, led the effort to insert the Volcker Rule in the Dodd-Frank act, the sweeping regulatory overhaul passed in response to the financial crisis. In a comment letter on Monday, the senators said the proposed rule was “too tepid.”
But the loudest response came from critics like Wall Street trade groups and banks, who want to soften the rule. The rule, the critics said, is a threat to the health of the financial industry and the broader economy.
“This will make the overall economy less stable and less conducive to growth,” David Hirschmann, head of the Center for Capital Markets Competitiveness at the Chamber of Commerce, said in a letter.
The pushback against the Volcker Rule is the latest effort under way on Wall Street to mute the impact of Dodd-Frank. But the campaign against the Volcker Rule is more pronounced than banks’ earlier attempts to temper new regulations for lending and derivatives.
Wall Street firms, lawyers and trade groups churned out many Volcker Rule appeals. The Securities Industry and Financial Markets Association, or Sifma, hired the law firm Davis Polk to write multiple pitches to regulators. A hodgepodge of Wall Street trade groups led by Sifma alone filed five comment letters on Monday, including one document that spanned 173 pages. A regulatory comment letter normally runs 10 to 20 pages. During the writing period, most big banks formed internal Volcker Rule “task forces,” often led by risk officers and lawyers, to coordinate the effort across trading desks and divisions, people briefed on the efforts said.
The letter writing went right down to the deadline. Over the weekend, a dozen or so lawyers huddled on the 17 floor of Davis Polk’s Midtown Manhattan headquarters, making final changes to more than 10 letters written on behalf of banks and Sifma.
“I’ve never seen a rule-making response like this before,” said Derek M. Bush, a partner at the law firm Cleary Gottlieb who helped write comment letters for banks and financial industry groups.
Wall Street’s biggest banks even submitted their own comment letters, taking an unusually aggressive stance that underscored the importance of the issue. Ordinarily, banks prefer to have trade groups and lobbyists do the talking for them.
But with profits — and the future model of the industry — at stake, Goldman Sachs [ http://dealbook.on.nytimes.com/public/overview?symbol=GS ], Morgan Stanley [ http://dealbook.on.nytimes.com/public/overview?symbol=MS ] and Citigroup [ http://dealbook.on.nytimes.com/public/overview?symbol=C ] each submitted a comment letter, people briefed on the matter said. The letters were not yet public, but they were expected to be filed before the midnight deadline.
“Firms usually feel that it’s best to work only with the trade group letter,” said Margaret E. Tahyar, a partner at Davis Polk who worked on several Volcker Rule comment letters. “But the Volcker Rule is such a major shift, that many, many firms felt they needed to also write letters in their own name.”
Banks have held meetings with regulators to spell out their case. Goldman officials have met six times [ http://www.sec.gov/comments/s7-41-11/s74111.shtml#meetings ] with the Securities and Exchange Commission [ http://topics.nytimes.com/top/reference/timestopics/organizations/s/securities_and_exchange_commission/index.html ] over the last three months.
The insurance industry also injected itself into the debate, arguing that regulators need not apply the Volcker Rule to their business, according to people briefed on the matter.
The scope of the Wall Street pushback reflects the complexity of the rule. The draft rule that regulators unveiled last October spans about 300 pages and poses some 1,300 questions for the public to address.
Now, the comment deadline ushers in a critical phase. Equipped with arguments from every side, regulators will turn their focus to completing details of the rule.
Still, it could take months for the five regulators — the Federal Reserve, the S.E.C., the Federal Deposit Insurance Corporation [ http://topics.nytimes.com/top/reference/timestopics/organizations/f/federal_deposit_insurance_corp/index.html ], the Commodity Futures Trading Commission [ http://topics.nytimes.com/top/reference/timestopics/organizations/c/commodity_futures_trading_commission/index.html ] and the Office of the Comptroller of the Currency [ http://topics.nytimes.com/top/reference/timestopics/organizations/c/comptroller_of_the_currency/index.html ] — to sift through the hundreds of comment letters. Financial industry lawyers have already forecast that regulators will miss the July deadline to put the rule into effect.
Wall Street, sensing opportunity in a delay, urged regulators to take their time. Some letters suggested that the regulators “repropose” the rule, or scrap the earlier proposal altogether and start from scratch.
Supporters of the Volcker Rule say that is a ploy to delay it until after the 2012 election, which may end the Democratic control of the Senate and the White House.
“It’s part of their ongoing strategy — if you can’t kill the rule, you may as well delay it as long as possible,” said Dennis Kelleher, president of Better Markets, a nonprofit group that advocates stricter financial regulation [ http://topics.nytimes.com/topics/reference/timestopics/subjects/c/credit_crisis/financial_regulatory_reform/index.html ].
The Volcker Rule aims to ban banks from placing bets with their own money, a practice known as proprietary trading. The rule is based on the belief that banks that enjoy government backing — like deposit insurance — should not be able to trade in this way.
Much of the debate over the Volcker Rule will center on defining what amounts to proprietary trading. The line can be blurred between proprietary trading and legitimate market-making, a practice in which banks hold securities with the intent of selling them to a customer. Regulators have acknowledged that deciphering that gray area is difficult.
The chief critics of the Volcker Rule have seized on the imprecision, saying that securities markets rely on banks holding large inventories of bonds so that investors can buy and sell them easily. The rule’s attempts to distinguish between trading and market-making “would have significant deleterious real-world effects on financial markets and on the investors and customers that rely on such markets for liquidity,” Sifma wrote in its comment letter.
But holding large amounts of securities has hurt banks. During the financial crisis, banks suffered huge losses on assets that were originally intended for clients, like the mortgage securities that meant big losses for Citigroup and Merrill Lynch [ http://topics.nytimes.com/top/news/business/companies/merrill_lynch_and_company/index.html ]. And banks’ inventories of financial assets ballooned in the years leading up to the financial crisis, leaving them particularly vulnerable to losses when customer demand for the assets dried up.
The rule’s supporters argue that banks are defining market making so broadly that it could include some forms of risky proprietary trading. “Holding substantial securities in a trading book for an extended period obviously assumes the character of a proprietary position, particularly if not specifically hedged,” Mr. Volcker wrote in his comment letter.
Or, as Mr. Kelleher put it, “Calling something market making doesn’t make it so.”
Copyright 2012 The New York Times Company
http://dealbook.nytimes.com/2012/02/13/at-volcker-rule-deadline-a-strong-pushback-from-wall-st/ [with comments]
===
Paul Volcker: Here Are 5 Ways To Know Prop Trading When You See It
Ben Walsh
February 13, 2012
Today, Paul Volcker [ http://www.businessinsider.com/blackboard/paul-volcker ] sent [ http://www.businessinsider.com/volcker-tells-his-haters-to-back-off-2012-2 ] his much anticipated letter [ http://www.sec.gov/comments/s7-41-11/s74111-182.pdf (last item below)] to regulators concerning the eponymous rule he championed restricting proprietary trading, along with an accompanying essay.
The premise of the rule is notoriously simple: proprietary trading is not an essential financial service and should not be allowed at institutions that have any form of explicit or implicit government support.
But how do you implement it?
Sure, there's out and out prop trading, which most banks who will be subject to the rule have by now jettisoned.
But what about the gray areas like market making, banks say? That's a vital function we provide and the Volcker rule shouldn't prohibit it. We have to buy and sell securities in anticipation of client demand, use our own capital to facilitate their trade views, etc., etc.
Well, Paul Volcker had heard the banks. And he's put the ball back in their court.
In his letter, he puts forward five metrics that both individually and in concert can be used to establish if a bank is violating the rule.
Oh, but first say Volcker, banks will need attentive CEOs, watchful boards of directors, robust control and reporting systems and above all a culture that 'puts clients first.'
But since there isn't a bank in the country that would publicly say it doesn't have any one of these things, let's move to the five metrics Volcker outlines in his letter:
1. "trading volume, and its relation to size of the trading 'book'"
2. "the volatility of earnings from trading"
3. "the extent to which those earnings are generated by pricing spreads rather than changes in price"
4. "the origination of trades (i.e. from customer initiative)"
5. "the close alignment of 'hedging' transactions with the composition of the trading positions"
The thrust of each of these metrics is that Volcker thinks it should be incumbent on banks to show that they're not using market making activities to engage in proprietary position taking. No single one of these metrics would in isolation demonstrate that a particular trade or desk or division or institution is or isn't prop trading.
But taken as a whole, they do get at many of the issues banks have raised with the rule.
Are banks holding a bunch of inventory on their books in the hope that it will rise in value, irrespective of whether they are even trading it that much? That doesn't sound like market making. See #1.
Do earnings from trading rise and fall dramatically from quarter to quarter? Market making in really liquid markets should a fairly steady, boring earnings generator. If not, see #2.
Is an institution making money on margin (spread) or asset value swings? The latter could be argued to be prop trading, with the customer used as a handy fall guy to exit a position. See #3.
Are banks doing a ton of trading but not really serving clients? Or are banks doing very little trading despite high volumes of client inquiry? In either case, see #4.
When does a hedge cease to be a hedge and become a proprietary position in and of itself? Re-watch the Goldman hearings chaired by Carl Levin. Actually, the answer is when the hedge is no longer connected to a risk embedded in a position and becomes a view on the price of securities in and of itself. See #5.
Volcker's message to banks: your serve.
Copyright © 2012 Business Insider, Inc. (emphasis in original)
http://articles.businessinsider.com/2012-02-13/wall_street/31054155_1_proprietary-trading-volcker-rule-banks [with comment]
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Sen. Levin Grills Goldman Sachs Exec On "Shitty Deal" E-mail
Uploaded by HuffPolitics on Apr 27, 2010
Senator Carl Levin (D-MI) and former Goldman Sachs Mortgages Department head Daniel Sparks, Senate Governmental Affairs Subcommittee on Investigations hearing, April 27, 2010
http://www.youtube.com/watch?v=gLx2Xc1EXLg
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Senate Hearing: Sen. Levin vs. Lloyd Blankfein, Goldman Sachs
Uploaded by Ralphdraw3 on May 31, 2011
http://www.thesoapboxroadshow.com/ WASHINGTON - Concluding a two-year bipartisan investigation, Senator Carl Levin, D-Mich., and Senator Tom Coburn M.D., R-Okla., Chairman and Ranking Republican on the Senate Permanent Subcommittee on Investigations, today released a 635-page final report (PDF, 6MB) on their inquiry into key causes of the financial crisis. The report catalogs conflicts of interest, heedless risk-taking and failures of federal oversight that helped push the country into the deepest recession since the Great Depression.
http://levin.senate.gov/imo/media/doc/supporting/2011/PSI_WallStreetCrisis_041311.pdf
http://www.youtube.com/watch?v=oOpFbjHcxF0
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February 13, 2012
DEPARTMENT OF THE TREASURY Office of the Comptroller of the Currency 12 CFR Part 44 Docket No. OCC-2011-0014 RIN: 1557-AD44
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 12 CFR Part 248 Docket No. R-1432 RIN: 7100-AD82
FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 351 RIN: 3064-AD85
SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 255 Release No. 34-65545; File No. S7-41-11 RIN: 3235-AL07
COMMODITY FUTURES TRADING COMMISSION 17 CFR Part 75 RIN: 3038-AD05
Subject: Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds.
This letter sets out my comments on your proposed rules implementing the portion of the Dodd-Frank legislation restricting proprietary trading and investment in hedge and equity funds by U.S. banking organizations. I have attached a more lengthy statement reviewing the policy considerations compelling the legislation and dealing with concerns about the impact on markets and competition, points that are sometimes lost amid the intense lobbying efforts on detailed implementation.
I cannot help but be impressed by the success the regulatory agencies so far in reaching agreement on the preliminary rule and by your confidence that the regulation can and will be successfully implemented. I am also certain that simplicity and clarity are challenging objectives, which for full success, require constructive participation by the banking industry. As I have suggested elsewhere, there should be a common interest in an approach that, to the extent feasible, is consistent with the banks’ broader internal controls and reporting systems.
My sense is that success is strongly dependent on achieving a full understanding by the most senior members of the bank’s management, certainly including the CEO, and the Board of Directors, of the philosophy and purpose of the regulation. As the rules become effective, periodic review by the relevant supervisor with the Boards and top management will certainly be appropriate, as a key part of the usual examinations process or otherwise.
The necessary understanding should be reflected in both the culture of the bank and in the written internal controls applicable to trading activities and to relations with hedge and equity funds that have an element of bank sponsorship and investment. Obviously, those controls must be consistent with the specifics of the regulation restricting proprietary trading.
At the other end of the process is the need for a set of “metrics” designed to reveal evidence of deliberately concealed and recurring proprietary trading. I know much effort has been made in that area. While I am not familiar with all the details, I do emphasize its importance.
I understand that such measures as trading volume, and its relation to size of the trading “book”, the volatility of earnings from trading, the extent to which those earnings are generated by pricing spreads rather than changes in price, the origination of trades (i.e. from customer initiative) and the close alignment of “hedging” transactions with the composition of the trading positions will be essential tools for supervisors and management to monitor the trading activities of firms.
To the degree those metrics can be made consistent with the banks’ internal reporting and control systems, both management control and simplicity will be greatly facilitated.
I realize that between those two requirements – management commitment and ex-post measurement of performance – lies the thorny issue of guidance with respect to defining the character of “market making” for customers. Clearly, 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, particularly if not specifically hedged. Various arbitrage strategies, esoteric derivatives, and structured products will need particular attention, 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, 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 (and should, of course, also be identified by a bank’s internal controls).
My understanding is that only a very few very large banking organizations engage in continuous “market making” on any significant scale. Clearly, it is those institutions that will require the attention of the regulatory authorities. I also understand that the lawful restrictions do 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 time 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.
I need not add that I continue to follow with interest your efforts to assure meaningful and effective execution of the law and fidelity to the important considerations of public policy that the law is intended to enforce.
[signed]
Paul A. Volcker
*
COMMENTARY ON THE RESTRICTIONS ON PROPRIETARY TRADING BY
INSURED DEPOSITARY INSTITUTIONS
By Paul A. Volcker
Full discussion by the public, and particularly by directly affected institutions, on the proposed regulations implementing the Dodd-Frank Act, as with all proposed rules, is necessary and important. It is also true that the commentary and debate may generate uncertainty and confusion along with useful and needed improvements. That has been apparent in responses to the proposed regulation implementing certain restrictions on proprietary trading by commercial banking organizations – the so-called “Volcker Rule”.
In sorting out the problems – the real from the imaginary, the truly important from the incidental – the basic logic and approach of the law deserves re-emphasis.
The basic public policy set out by the Dodd-Frank legislation is clear: the continuing explicit and implicit support by the Federal government of commercial banking organizations can be justified only to the extent those institutions provide essential financial services. A stable and efficient payments mechanism, a safe depository for liquid assets, and the provision of credit to individuals, governments and business (particularly small and medium-sized businesses) clearly fall within that range of necessary services. Proprietary trading of financial instruments – 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, deposit insurance or emergency support.
In fact, the comfort for creditors and others inherent in the ability of institutions engaged in proprietary trading to resort to the Federal “safety net” can only tend to encourage greater leverage and risk-taking. Commercial bank proprietary trading is thus at odds with the basic objectives of financial reforms: to reduce excessive risk, to reinforce prudential supervision, and to assure the continuity of essential services.
The questions and objections raised in comments on the proposed rules appear to fall into four broad categories:
1. Proprietary trading by commercial banks is not an important risk factor;
2. Needed liquidity in trading markets will be imperiled;
3. The competitive position of U.S. based commercial banking institutions will be adversely affected;
4. The proposed regulation is simply too complicated and costly.
My short answer to each of these objections is: “not so”. I will comment on each of them in turn.
THE RISK
On its face, proprietary trading entails substantial risks. It is essentially speculative in nature: securities are bought, held and sold in the expectation of profits from changes in market prices. The recent years of financial crisis have 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.
Demonstrably, internal controls are difficult to establish and to implement in active and highly complex markets. In critical instances they proved woefully inadequate. Consequently, the stability of important banks was jeopardized, contributing to a financial crisis of historic dimension.
The pressures on the big, American investment banks actively engaged in proprietary trading were the leading case in point. They required substantial government (i.e., taxpayer) assistance both before and more dramatically after the Lehman bankruptcy. Either directly or by merger with a commercial bank, the largest investment banks acquired a banking license, in effect being accorded the comfort of access to massive Federal Reserve and FDIC assistance.
To be sure, there were many factors other than proprietary trading contributing to the breakdown of financial markets. The speculative “bubble” in housing prices and the subsequent declines, excessive leverage by banks and other institutions (including the overuse and abuse of derivatives), inadequacies in accounting practices, and certainly the lack of regulatory oversight all contributed. Many of the losses within the thinly capitalized commercial banking system simply reflected weak underwriting practices. In that sense, proprietary trading, and the related activity of sponsorship and investment in hedge and equity funds, were not alone in causing the crisis. Many factors were involved. However, losses within large trading positions were in fact a contributing factor for some of our most systemically important institutions, and proprietary trading is not an essential commercial bank service that justifies taxpayer support.
The need to restrict proprietary trading is not only, or perhaps most importantly, a matter of the immediate market risks involved. It is 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. Can one group of employees be so richly rewarded, the traders, for essentially speculative, impersonal, short-term trading activities while professional commercial bankers providing essential commercial banking services to customers, and properly imbued with fiduciary values, be confined to a much more modest structure of compensation?
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, 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.
LIQUIDITY
As a general matter, efficient markets do need arrangements to facilitate trading in financial instruments. That ability to buy and sell large volumes of assets on short notice (termed “liquidity”1) appeared, prior to the crisis, to be greatly enhanced. There should not, however, be a presumption that evermore market liquidity brings a public benefit.
At some point, great liquidity, or the perception of it, may itself encourage more speculative trading, even in longer-term instruments. Presumably conservative institutional investors are tempted to turn over positions much more rapidly, at the expense of careful analysis of basic values.
In the light of events, careful consideration of the benefits and possibly damaging consequences of increased liquidity has become the subject of new studies and commentary by economists and regulators. A consensus may be developing that beyond some point, little or no public benefit may be evident2.
In any event, the restrictions on proprietary trading by commercial banks legislated by the Dodd-Frank Act are not at all 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: give up either their proprietary trading activity or their banking license. The apparent reluctance to do the latter only reinforces the perceived value of access to the Federal safety net and the substantial implicit subsidy to borrowing costs.
In essence, proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens. That, in essence, was the de facto distinction maintained until the last decade or two. 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.
COMPETITION
The argument that United States banking organizations will suffer in their competitive position vis-à-vis international banks seems superficial at best, and more likely proprietary trading is counter to their prospects. Competition in banking, here as elsewhere, is desirable for the benefits it brings in institutional efficiency and better, more economical service to customers. Any contribution of proprietary trading to customer service and competition is not at all obvious. In fact, because of the risks, the conflicts of interest and the adverse cultural influence it may well impede effective competition.
Deposit and payment facilities, the providing of credit, and asset management – these 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?
Restrictions on proprietary trading offer customers a “conflict of interest” free platform, 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 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.
COMPLEXITY
The complexity and potential costs of any rule-making in the world of modern finance presents a challenge. Enforcement of the restrictions required by the Volcker Rule is no exception. In approaching this problem, let us not lose sight of the fact that existing risk management practices of large financial institutions here and abroad, including some major
U.S. commercial banks, fundamentally failed, at great cost to financial stability and the world economy. Hopefully, lessons have been learned. Both regulators and the regulated have been compelled to review previous practices, including various “metrics” to measure risk and to specifically control trading activity.
The regulators have released a “first draft”. They have provided ample opportunity for comment. As in other areas, judgments must be made about the balance between detailed
rules and a more principle-based approach – conceptualized as “Trust but Verify”3. Proprietary trading in any real volume is confined to a very few large, sophisticated U.S. banks: it has been reported that only six banks account for almost 93 percent of the trading revenue of all American banks. Purely proprietary activity is likely to have been even more concentrated.
CONCLUDING COMMENTS
In all their complexity, our giant banks are not easy institutions to manage. They need active leadership, an alert Board of Directors, internal controls, and even more a strong cultural tradition of “the customer comes first”. By their nature, they also have both large resources and a reservoir of management and technical talent.
The Federal regulators have enormous challenges of their own. They have also had a great learning experience, and have been tested beyond memory. Writing effective regulations to carry out all of the Dodd-Frank Act requires the best talent the regulating agencies have. And, at the end of the day, I feel confident that the restrictions imposed by the “Volcker Rule” can be reasonably and effectively administered.
With active cooperation among the agencies and with constructive consultation instead of futile stonewalling, an important reform can soon be put in place.
1 In most contexts, “liquidity” is defined as financial instruments thatare inherently safe, short-term, and readily turned into cash with littlerisk of loss (i.e., Treasury Bills). “Market liquidity”, defined as theease of trading any financial (or even non-financial) instrument, is moreintangible, and depends upon the particular circumstances.
2 See, for instance, lectures by Lord Adair Turner, Chairman of the U.K.Financial Services Agency entitled “What Do Banks Do, What Should They Do,And What Public Policies Are Needed To Ensure Best Results For The Real Economy”, 17 March 2010 and “Economics, Conventional Wisdom And PublicPolicy”, April 2010. Much earlier, in 1989, Lawrence and Victoria Summerswrote a prescient analysis, warning against excessive liquidity,concluding that the need for a Transaction Tax should be explored. In the1930’s, John Maynard Keynes also questioned excessive emphasis onliquidity.
3 I deal with these matters in my comment letter more fully.
*
http://www.sec.gov/comments/s7-41-11/s74111-182.pdf
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Greensburg, KS - 5/4/07
"Eternal vigilance is the price of Liberty."
from John Philpot Curran, Speech
upon the Right of Election, 1790
F6
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