Volcker on Volcker: Former Federal Reserve Chairman Addresses Arguments against Proprietary Trading Reforms
Alex Kreonidis | Bloomberg Law
Former Federal Reserve Chairman Paul A. Volcker submitted a comment letter on proposed rules that would implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The Securities and Exchange Commission and banking regulators solicited comments on a joint rule they proposed in October 2011. The Commodity Futures Trading Commission itself proposed a substantively similar rule last month. Section 619 (as well as the proposed rules) generally prohibits any banking entity from engaging in proprietary trading or having certain interests in, or relationships with, hedge funds and private equity funds (subject to a number of exemptions). Volcker himself was the inspiration for Section 619, which is commonly called the “Volcker Rule.” For background on the proposals, see Agencies Issue Much Anticipated Volcker Rule Proposal, Bloomberg Law Reports® – Securities Law, Vol. 5, No. 43 (Oct. 24, 2011), and Divided CFTC Issues Volcker Rule Proposal Mirroring Earlier SEC, Banking Regulator Proposal, Bloomberg Law Reports® – Derivatives Law, Vol. 3, No. 3 (Feb. 6, 2012).
Although the proposals took hundreds of pages to explain and solicited public input on a seemingly endless list of questions, Volcker’s comments were brief, spanning a modest eight pages. He affirmed his support for the proposals and addressed the necessary process needed for successful implementation. He also responded to four broad categories of objections raised by those critical of the proposals’ ban on proprietary trading:
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; [and]
4. The proposed regulation is simply too complicated and costly.
Successful Implementation of Volcker Rule
Volcker identified two high-level requirements for successful implementation of the Volcker Rule: a commitment by banking entities and their management to comply with the rule’s prohibitions and restrictions; and an appropriate set of reporting metrics to be used by regulators to “reveal evidence of deliberately concealed and recurring proprietary trading.” Ensuring both are reflected in the bank’s internal controls also will be key and further help facilitate compliance. Nevertheless, Volcker acknowledged that between “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.” He suggested, however, that difficult interpretative issues regarding acceptable market making activities will be the exception, rather than the norm, and be limited to “very few very large banking organizations.”
Rationale for Proprietary Trading Ban and Response to Critics
Volcker also addressed objections leveled against the proposed rules’ ban on proprietary trading. He did so in the context of Dodd-Frank’s public policy goals. As Volcker posited, “[t]he 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.” [emphasis omitted].
Essential financial services does not include proprietary trading, Volcker continued, because it primarily benefits a limited group of highly paid employees and the bank’s shareholders. Moreover, according to Volcker, proprietary trading contradicts other basic objectives of Dodd-Frank’s financial reforms: “to reduce excessive risk, to reinforce prudential supervision, and to assure the continuity of essential services.” [emphasis omitted].
— Proprietary Trading Is Not an Important Risk
Volcker argued that proprietary trading by banks entails substantial risks and undermines “the financial services industry as a service industry.” He asserted that 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.” Volcker also seemed to suggest that the risks of proprietary trading increased after the largest investment banks acquired banking licenses and “access to massive Federal Reserve and FDIC assistance.”
— Liquidity Will Be Imperiled
Volcker took on the liquidity issue by directly questioning whether “evermore market liquidity brings a public benefit,” given that “[a]t some point, great liquidity, or the perception of it, may itself encourage more speculative trading, even in longer-term instruments.” In any event, Volcker argued that trading in equities is still dominated by exchanges and not a main focus area for commercial bank trading activity. Although trading in debt securities and derivatives has become an important trading activity for a few commercial banks, Volcker argued simply that such institutions are faced with a choice: “give up either their proprietary trading activity or their banking license.”
— Competitive Position of U.S. Banks Will Be Adversely Affected
Looking at the core services provided by commercial banks, namely, “deposit and payment facilities, the providing of credit, and asset management,” Volcker did not see any competitive impediments for U.S. banks. If anything, Volcker argued that “[r]estrictions 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.”
— Proposals Are Overly Complicated and Costly
While acknowledging the proposals are complex and potentially costly, Volcker also stressed that “existing risk management practices at 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.” In essence, he argued that regulatory changes are necessary to avoid repeating the mistakes of the financial crisis, and the rulemaking process, with its ample opportunity for comment, will find the right balance. “With active cooperation among the agencies and with constructive consultation instead of futile stonewalling,” Volcker concluded, “an important reform can soon be put in place.”
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
©2012 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.