Volcker plan

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See also bank tax and proprietary trading.


How the new rule will be implemented

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Reform Act"). This alert focuses specifically on the effects of the so-called "Volcker Rule," contained in Section 619 of the Reform Act, and is one in a series of alerts on the Reform Act.

Lawmakers left many of the key details of financial reform to regulation to be determined by the regulators. Various industry experts have estimated that the new law will require U.S. regulatory agencies to enact over 200 new regulations. Others have asserted that the rulemaking effort required to implement the Reform Act will be unprecedented in its scope and complexity and will exceed the efforts required to implement the post-September 11th measures and the Sarbanes-Oxley Act. As a result, U.S. regulatory agencies will need to enact numerous regulations implementing the Reform Act and, in doing so, will have the opportunity to shape the ultimate effect of financial reform in many critical areas, including the implementation of the Volcker Rule.

A. Introduction

Section 619 of the Reform Act enacts a version of the "Volcker Rule" originally proposed by President Obama and White House economic advisor Paul Volcker in January of 2010 (the "Volcker Rule"). The Volcker Rule is intended to help prevent the occurrence of another financial crisis by reducing or eliminating high-risk speculation at financial institutions and encouraging such institutions to focus instead on lower-risk, client-focused activities.

The Volcker Rule is controversial because it is unclear whether the activities that it prohibits contributed significantly, if at all, to the financial crisis, and, in a number of cases, these activities may have provided valuable sources of income for banks experiencing historic losses in their traditional loan portfolios. Nevertheless, the Volcker Rule has attracted significant political support from legislators eager to reduce both the perceived risk in the financial system and the perceived excesses of Wall Street during the financial crisis.

The Volcker Rule includes two primary restrictions on the activities of any "banking entity." These restrictions are:

  • Prohibitions on "proprietary trading"; and
  • A ban on certain hedge fund and private equity activities and investments.

The Volcker Rule defines "banking entity" as any insured bank or thrift, a company that controls an insured bank or thrift, a company that is treated as a bank holding company under Section 8 of the International Banking Act of 1978 and any affiliate of such entity. Nonbank financial companies (other than savings and loan holding companies) are not subject to the restrictions set forth in the Volcker Rule.

However, nonbank financial companies supervised by the Board of Governors of the Federal Reserve System (the "Federal Reserve") that engage in activities prohibited by the Volcker Rule will be subject to additional capital requirements for and quantitative limits on proprietary trading or ownership interests in or sponsorship of a hedge fund or private equity fund, as well as rules imposing additional capital charges or other restrictions to address the affiliated transactions concerns of the Federal Reserve.

B. Study and Regulations

The Volcker Rule provides that, not later than January 21, 2011, the newly-established Financial Stability Oversight Council (the "Council") must study and make recommendations on implementing the provisions of the Volcker Rule. Not later than nine months after the completion of such study, regulations must be promulgated implementing the Volcker Rule. These regulations must be promulgated by:

  • The federal banking regulators jointly with respect to depository institutions;
  • The Federal Reserve with respect to bank holding companies and savings and loan holding companies, any company that is treated as a bank holding company for the purposes of Section 8 of the International Banking Act, any nonbank financial company supervised by the Federal Reserve, or any subsidiary of the foregoing;
  • The Commodities Futures Trading Commission ("CFTC") with respect to any entity for which it is the primary financial regulatory agency; or
  • The Securities and Exchange Commission ("SEC") with respect to any entity for which it is the primary financial regulatory agency.

Each of these regulators is required by statute to "consult and coordinate" with each other to ensure that such regulations are comparable to one another and do not provide advantages or impose disadvantages to companies governed by the Volcker Rule by virtue of which entity regulates them. The Chairperson of the Council shall be responsible for the coordination of these regulations.

C. Ban on Proprietary Trading

The Volcker Rule amends Section 13(a) of the Bank Holding Company Act of 1956 (the "BHCA") to prohibit expressly any banking entity from engaging in "proprietary trading."

The term "proprietary trading" means engaging as a principal for the trading account of the banking entity in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, derivative, contract of sale of a commodity for future delivery, any option on any such security, derivative or contract, or any other security or financial instrument that the appropriate federal banking agencies, the SEC or the CFTC may, by rule, provide.

The term "trading account" means any account used for acquiring or taking positions in the securities and instruments described above principally for the purpose of selling in the near term (or otherwise profiting from short term price movements) and any other such accounts that the appropriate federal banking agencies, the SEC or the CFTC may, by rule, provide.

While the Volcker Rule prohibits trading in securities for a banking entity's trading account as opposed to trading for the account of a customer, the following activities are expressly permitted by the Volcker Rule:

  • Trading in U.S. government or agency securities or obligations;
  • Trading in obligations, participations or other instruments issued by government sponsored enterprises, including Ginnie Mae, Fannie Mae, Freddie Mac, any Federal Home Loan Bank, Farmer Mac and any Farm Credit System institution chartered under the Farm Credit Act of 1971;
  • Trading in State or municipal obligations;
  • Acquiring or disposing of securities in connection with underwriting or market making activities;
  • Bona fide risk-mitigating or hedging activities;
  • Trading on behalf of the account of a customer;
  • Investing in small business investment companies;
  • Trading by a regulated insurance company for the general account of such insurance company in compliance with insurance company investment regulations;
  • Proprietary trading conducted by a banking entity pursuant to Sections 4(c)(9) (activities conducted by foreign banks, the greater part of which are conducted outside of the United States) or 4(c)(13) (shares of, or activities conducted by, an entity which does not do business in the United States) of the BHCA solely outside the United States, provided that the banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or one or more States; or
  • Any other activity that the appropriate federal banking agencies, CFTC or SEC, as applicable, determine by rule would promote and protect the safety and soundness of the banking entity or U.S. financial stability.
D. Ban on Ownership of Private Equity Funds and Hedge Funds

The Volcker Rule amends Section 13(a) of the BHCA to prohibit expressly any banking entity from organizing and offering a private equity or hedge fund, or sponsoring a hedge fund or private equity fund. Private equity funds and hedge funds are defined as an issuer that would be an investment company, as defined in the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of such Act, or such similar funds as the appropriate federal banking agencies, SEC or CFTC, as applicable, determine by rule. Sponsoring a fund means serving as a general partner, managing member, or trustee of the fund and in any manner selecting or controlling (or having employees, officers, directors, or agents who constitute) a majority of the directors, trustees or management of that fund, or sharing the same name or variation of such name for corporate, marketing, promotional or other purposes.

The prohibitions on private equity and hedge fund activities are subject to exceptions for certain enumerated permitted activities. Such permitted activities are discussed below.

Bona Fide Trust or Investment Advisory Services. A private equity or hedge fund activity will be deemed to be a permitted activity if it meets all of the following conditions:

  • The banking entity must provide bona fide trust, fiduciary or investment advisory services. Although the Volcker Rule does not define what are considered "investment advisory services," Section 202(a)(11) of the Investment Advisers Act of 1940 defines an investment adviser as any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities. While banks are excepted from being considered an "investment adviser," the definition provides guidance in determining whether a banking entity is actually providing such services to the funds;
  • The fund is organized and offered only in connection with the provision of the bona fide trust or investment advisory services and only to persons who are customers of such services of the banking entity. The purpose of this condition is to limit the fund activities of banking entities to those activities provided solely as a service to existing customers and not intended to be a separate business unrelated to the banking clients. To satisfy this condition, the investors in funds must be willing to establish accounts with the relevant banking entity (or its affiliate);
  • The banking entity does not acquire or retain an interest in the funds except for a de minimis investment. A "de minimis investment" is an investment in a hedge fund or private equity fund in which (i) the banking entity actively seeks unaffiliated investors to reduce or dilute its investment, (ii) the banking entity's investment is reduced to not more than 3% of the total ownership of the fund within one year of the fund's establishment (with a possible two year extension) and (iii) the investment is immaterial to the banking entity as defined by regulators pursuant to rulemaking, but in no case in excess of 3% of the banking entity's Tier 1 capital;
  • The banking entity complies with Sections 23A and 23B of the Federal Reserve Act and Regulation W promulgated thereunder (transactions with affiliates limits);
  • The banking entity does not guarantee the obligations or performance of any fund;
  • The banking entity does not share the same name with any fund for corporate or marketing purposes;

No director or employee of the banking entity retains an interest in the fund (unless directly engaged in providing investment advisory services to the fund); and

  • The banking entity provides full disclosure to investors, including that the risk of loss borne by investors.
Foreign Activities. The Volcker Rule permits the ownership or sponsorship of a private equity or hedge fund by a banking entity pursuant to Section 4(c)(9) or 4(c)(13) of the BHCA solely outside the United States, provided that
  • No ownership interest in such hedge fund or private equity fund is offered for sale or sold to a resident of the United States; and
  • The banking entity is not directly or indirectly controlled by a banking entity that is organized under the laws of the United States or one or more States.
Seed Money or Other De Minimis Investments. A banking entity also may make and retain an investment in a hedge fund or private equity fund that the banking entity organizes and offers for the purposes of
  • Establishing the fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors; or
  • Making a de minimis investment (as defined above).

E. Limitations on Permitted Activities

The permitted activities exceptions to both the proprietary trading and private equity prohibitions of the Volcker Rule are subject to certain qualifications. Specifically, no transaction, class of transactions or activity will be deemed to be a permitted activity if it would:

  • Involve a material conflict of interest between the banking entity and its customers, clients or counterparties;
  • Result, directly or indirectly, in a material exposure to high risk assets or high risk trading strategies;
  • Pose a safety and soundness threat to the banking entity; or
  • Pose a threat to U.S. financial stability.

F. Capital and Quantitative Limits

The appropriate federal bank agencies, the SEC and the CFTC, as applicable, must adopt rules imposing additional capital requirements and quantitative limitations, including diversification requirements, regarding all permitted activities if such regulators determine that such additional capital requirements and limitations are necessary to protect the safety and soundness of banking entities engaged in such activities. For the purposes of determining compliance with applicable capital standards, the aggregate amount of outstanding investments by a banking entity, including retained earnings, will be deducted from assets and tangible equity of the banking entity, and the amount of the deduction will increase commensurate with the leverage of the hedge fund or private equity fund.

In addition, a banking entity that continues to own a private equity fund or hedge fund pursuant to a permitted activity exception is required to seek unaffiliated investors to reduce or dilute its investment to not more than 3% of the total ownership interests in the fund and an amount that is immaterial to the banking entity, provided that in no case may the banking entity's aggregate interests in all private equity and hedge funds exceed 3% of the banking entity's Tier 1 capital.

G. Section 23A and 23B Limitations

A banking entity that serves, directly or indirectly, as the investment manager, investment adviser or sponsor to a hedge fund or private equity fund or any affiliate of such banking entity or a banking entity that organizes and offers a hedge fund or private equity fund pursuant to the "seed money" or "de minimis investment" exceptions discussed above:

  • May not enter into a transaction with such fund, or any other funds that such fund controls, which would constitute a "covered transaction" under Section 23A of the Federal Reserve Act; and
  • Will be subject to Section 23B of the Federal Reserve Act;

as if such banking entity were a Federal Reserve member bank and such hedge fund or private equity fund were an affiliate of such member bank.

Notwithstanding these restrictions, a banking entity may enter into "prime brokerage transactions" with any hedge fund or private equity fund in which a hedge fund or private equity fund managed, sponsored, or advised by such banking entity has taken an ownership interest, provided that certain conditions are met.

H. Effective Date and Transition Period

The Volcker Rule does not become effective until the earlier of (i) 12 months after the issuance of final rules implementing the Volcker Rule; and (ii) two years after enactment of the Reform Act (the "Effective Date"). A banking entity will then have two years after the Effective Date to "bring its activities and investments into compliance" with the Volcker Rule. Therefore, as a practical matter, a banking entity may not need to be in compliance with the rule until July of 2014.

In addition, the Federal Reserve may grant up to three one-year extensions of the transition period if "consistent with the purposes of this section" and "not detrimental to the public interest." It is not clear whether the Federal Reserve will grant such extensions as a matter of course (as federal banking regulators routinely do with respect to impermissible investments acquired in acquisition transactions or after charter conversions) or whether the Federal Reserve will be reluctant to grant such extension requests.

Additional extensions of up to five years are available in connection with commitments to funds considered to be "illiquid." Assuming a July 21, 2012 Effective Date, a banking entity will have between 4 and 12 years from July 21, 2010 to comply with the Volcker Rule before it will be required to cease its proprietary trading activities or divest its interest in private equity or hedge funds.

I. Analysis

At first glance, it appears that, once the Volcker Rule is effective, banking entities will be compelled, subject to the transition periods discussed above, to conform their proprietary trading activities and private equity and hedge fund activities to the requirements of the Volcker Rule or to close, divest or spin off these activities.

In this regard, several news agencies reported last week that two large investment banks have decided to close their proprietary trading operations. The decision to close, rather than sell or spin off, proprietary trading operations may be motivated by a combination of factors, including the relatively small size of such operations, the risks entailed and personnel reasons, as well as the new regulatory compliance burden.

However, the statutory language is broad enough that banking entities may be able to continue to engage in these activities if they make minor modifications to their business models. For instance, the definition of proprietary trading is broad enough that banking entities may be able to continue to engage in their current trading activities simply by altering the participant in or timing of various trades. As discussed above, the term "proprietary trading" applies only to "engaging as a principal for the trading account of the banking entity in any transaction."

Banking entities may be able to continue to engage in the same types of trading activities in which they currently engage by making the trades on an agency rather than a principal basis. Similarly, the term "trading account" means any account used "principally for the purpose of selling in the near term (or otherwise profiting from short term price movements)." The statute does not define what is meant by "selling in the near term (or otherwise profiting from short term price movements)."

Accordingly, banking entities may be able to continue to engage in their current trading activities, even on a principal basis, by extending the time frame of the trades so that they are not done in the "near term" or otherwise structured to profit from "short term price movements."

In addition, banking entities will still be able to trade, on a principal basis, in government and agency securities and will remain able to maintain long term investments in their investment portfolios as opposed to in private equity or hedge funds.

While the regulations that will be adopted by the various regulatory agencies may remove some of the ambiguity in the statutory language, it is likely that banking entities will be able to continue to engage in many of their current trading activities simply by taking advantage of the exceptions set forth in the Volcker Rule.

With respect to private equity or hedge fund activities, despite the extended compliance timeline, many banking entities have already begun the process of taking steps to comply with the Volcker Rule.

Several money center banks have announced or completed plans to divest or spin off certain of their private equity or hedge fund investments.

Other such banks are expected to take full advantage of the transition period and gradually reduce their ownership in private equity funds and hedge funds over time rather than selling or spinning them off at once. One large financial institution is rumored to be considering moving its proprietary trading operations into a hedge fund and making its traders hedge fund managers.

Such institution would then provide seed capital for such hedge fund and have the fund raise additional capital from unaffiliated investors in order to reduce the institution's ownership to a level that complies with the Volcker Rule's restrictions on ownership of private equity funds and hedge funds.

However, the timing of the announced transactions and speed at which compliance plans are being formulated indicate that the banking entities have been considering divestitures, spin offs or other strategic changes in their proprietary trading or fund ownership activities for internal business planning reasons rather than in response to the inclusion of the Volcker Rule in the Reform Act.

The transactions may also reflect a desire by certain funds and their management to access third party capital and diversify their investor base rather than be owned by one large, heavily regulated banking entity. Based on the numerous different approaches banking entities have chosen or are considering to comply with the Volcker Rule, it is clear that there is ample room for banking entities to creatively structure a plan to comply with the Volcker Rule in a manner that is advantageous to both the banking entities and individuals involved.

In addition, the coming months and years will reveal whether the Reform Act will open up opportunities for non-U.S. financial institutions in the U.S. to compete for business against highly regulated U.S. financial institutions and whether the Reform Act's provisions, including the Volcker Rule, will cause U.S. financial institutions to contract their growth in certain areas of business allowing foreign competitors to fill this void.

House colloquy clarifies scope of Volcker rule in Dodd-Frank

Section 619 of Dodd-Frank Act, the Volcker Rule, prohibits firms from investing in traditional private equity funds and hedge funds. Rep. Jim Himes (D-CT), a member of the Financial Services Committee, noted that because the legislation uses the very broad Investment Company Act approach to define private equity and hedge funds, it could technically apply to lots of corporate structures, and not just the hedge funds and private equity funds.

A colloquy between House Financial Services Chair Barney Frank and Rep. Himes clarified that, when firms own or control subsidiaries or joint ventures that are used to hold other investments, the Volcker Rule won’t deem those things to be private equity or hedge funds and disrupt the way the firms structure their normal investment holdings. Chairman Frank added that Congress does not want excessive regulation here.

He is confident that the regulators will appreciate that distinction and maintain it, and that the congressional oversight committees will make sure that they do. (Cong. Record, June 30, 2010, p. H5226).

Administration's proposed Volcker rule

Legislation put forward by the Obama administration would ban some banks from investing in hedge funds or private equity funds and from making trades not for the benefit of their customers. Related Article »

In January, the President announced a proposal to limit the size of financial firms and the risky activities of banks. Today, the Treasury has delivered proposed legislative text to implement these reforms to Capitol Hill. These proposals are part of a comprehensive package of reforms to create a safer, more resilient financial system. This legislative language adds to existing activity restrictions for banking firms by prohibiting such firms from engaging in proprietary trading and from investing in or sponsoring hedge funds or private equity funds. This language would also supplement and strengthen existing financial sector concentration limits.

Banking firms would be banned from proprietary trading:

We need to bolster existing restrictions on banking firms’ activities to make the system safer and protect the taxpayer and keep banking firms focused on serving their customers. The proposed legislation would ban banking firms from engaging in “purchasing or selling, or otherwise acquiring and disposing of, stocks, bonds, options, commodities, derivatives, or other financial instruments for the institution’s or company’s own trading book, and not on behalf of a customer, as part of market making activities, or otherwise in connection with or in facilitation of a customer relationship (including hedging activities related to the foregoing).”

Banking firms would be banned from investing or sponsoring hedge funds and private equity funds:

Banking firms would also be banned from investing in or sponsoring hedge funds, private equity funds, or other similar funds that are exempt from registration under Investment Company Act. The prohibition on sponsoring these private funds would include acting as a managing member or general partner of a fund, controlling the management of a fund, or sharing the firm’s name with a fund.

Banking firms would be banned from lending or providing prime brokerage services to, or bailing out, private funds advised by the firm. Banking firms would continue to be able to serve as investment adviser to private funds, but would be prohibited from lending, providing prime brokerage services, or engaging in any transactions that provide support to a private fund advised by the banking firm. Investors in private funds advised by banking firms must have no expectation that the banking firm would bail out the funds in times of stress.

Quantitative limits and additional capital requirements for major non-bank financial firms engaged in proprietary trading:

The proposed legislation would allow non-bank firms to continue to engage in proprietary trading and hedge fund and private equity activities, but would not allow major financial firms to escape tough supervision and oversight. These firms will be under tough consolidated supervision, more stringent capital and liquidity requirements, and be required to provide more information to the market about their risks. Moreover, any financial firm that is identified for heightened supervision under the Administration’s regulatory reform proposal would be subject to additional capital and quantitative limits on these activities.

Financial firms would not be allowed to grow by acquisition above 10% of the liabilities of the financial system:

The existing cap on deposit concentrations has become less effective as large banking firms have increasingly relied on other sources of funding, and has given these firms an incentive to shift towards riskier sources of funding. We need to update existing concentration limits to check future growth of our largest financial institutions and to make the system safer. The proposal would not allow a financial firm to acquire another company if the resulting firm would have more than 10% of the liabilities of the financial system.

March Senate draft requests “further study” of Volcker rule

Typically when Congress asks for “further study” about an issue, it is a sign that it is as good as dead.

That seems to be the fate of former fed chairman Paul Volcker’s proposed ban on proprietary trading at bank holding companies.

Sen. Christopher Dodd financial reform package released Monday directs the Government Accountability Office to study the “risks and conflicts associate with proprietary trading” by bank holding companies. The bill adds that the rule “should be” implemented at an undisclosed time in the future, but gives no specifics.

Among the issues the GAO study is supposed to clarify: Whether proprietary trading is systemically risky to the financial system or whether it presents a material risk to the “safety and soundness” of the banks.

The GAO has 15 months to report back to Congress about its findings. By then, financial reform may well be complete. And in the meantime, some Wall Street banks are already cranking up their prop trading machines , apparently impervious to any future Volcker-izing.

As the Huffington Post points out, Citigroup is making a “significant wager that the rule won’t be enacted anytime soon.” Bloomberg reported that Kevin Russell, head of Citigroup’s stock trading in the Americas, told employees that the bank may increase its prop trading unit’s capital. Russell also said the bank is seeking to hire new employees to replace those who left.

Undaunted, Volcker said recently that he’s thinking very long term about the need for prop trading limits.

“I may not live long enough to see the next crisis. But my soul is going to come back to haunt you,’’ the former Fed chair warned Senators at a hearing about the Volcker Rule last month.

S 3098 Senators Levin & Merkley write legislation to implement Volcker rule

WASHINGTON, D.C. – United States Senators Jeff Merkley (OR), Carl Levin (MI), Ted Kaufman (DE), Sherrod Brown (OH), and Jeanne Shaheen (NH) put forward a new proposal today to help prevent taxpayer bailouts of financial firms by limiting high-risk speculation, also known as proprietary trading.

“There is a place for high-risk speculation on the prices of stocks or securities, but these bets can no longer be allowed to threaten our entire financial system,” said Merkley. “Taxpayers should never again be told that they have to save bankers from their bad bets.”

“With this bill, we attempt to rein in risky proprietary trading by firms whose failures wreak havoc on our financial markets and our taxpayers,” Levin said. “Risky trading by a handful of major firms contributed to the collapse of the some of the largest financial firms in the world, hundreds of billions of dollars in losses to taxpayers, and the devastation of the entire world economy. This legislation is aimed at preventing high-risk trading strategies adopted by a few firms from leading to another crisis.”

"Congress has to draw hard lines to deal with 'too big to fail' and prevent another financial crisis. We must restore the wall between federally insured banks and risky proprietary trading," said Kaufman.

“For years, investment banks packaged and sold toxic financial products and then used their own money to bet against these products. Banks got rich, investors got hosed, and taxpayers got stuck with the bill. It’s time for Congress to rein in Wall Street greed and end these conflicts of interest,” said Brown.

“The American people brought our economy back from the brink of a complete economic meltdown caused by the poor decisions of big Wall Street banks,” said Shaheen. “We need to protect taxpayers by making sure these Wall Street firms can’t engage in the same risky behavior.”

The Protect our Recovery through Oversight of Proprietary Trading Act (or PROP Trading Act) would restrict these trades at banks and other large, important financial institutions. By keeping our 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 bill:

  • Bars banks, bank holding companies, and their affiliates and subsidiaries from engaging in high risk speculation involving any stock, bond, option, commodity, derivative, or other security or financial instrument. Also bars those entities from investing in or sponsoring a hedge fund or private equity fund.
  • 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 bill also puts strict limits on the amount of such speculation.
  • Prohibits securities brokers from betting against the packages of loans (asset-backed securities) they are promoting to their clients.

The PROP Trading Act is intended to reduce high-risk speculation at our nation’s critical financial institutions, encouraging them instead to focus on lower-risk, client-oriented services.

In addition, the PROP Trading Act would address fundamental conflicts of interest associated with the sale of packages of securities made up of loans. 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.

This legislation has been endorsed by business and investment leaders John Reed, the former Chair and CEO of Citibank, Bill Hambrecht, Chairman and CEO of WRHambrecht + Co, and Jeremy Grantham, Chairman of Grantham, Mayo, Van Otterloo & Co; leading academics Joseph Stiglitz, Robert Reich and Robert Johnson, Director of Economic Policy for the Roosevelt Institute; and major organizations calling for real Wall Street reform, including the Independent Community Bankers of America, Americans for Financial Reform, and the AFL-CIO.

A group of Senate Democrats is championing legislation to quash big banks’ high-risk trading activities, even though the measure was deemed dead on arrival last week by top Senate financial reform negotiators.

It’s is the latest public sign that members of the wider Democratic caucus are unhappy with the direction Republicans are pushing the legislation during the committee-level negotiations with Senate Banking Chairman Chris Dodd.

And it could portend trouble on the Senate floor for any deal Dodd strikes with his Republican partners.

“The bill has not gone through the banking committee; this is the time to have the debate,” said Sen. Jeff Merkley (D-Ore.), a member of the banking committee and a top sponsor of the legislation, which would ban commercial banks from engaging in what’s known as proprietary trading – using their own money to trade stocks, bonds and other products. The legislation closely mirrors what the White House has pitched to Congress – known as the “Volcker rule” for its architect, former Fed Chairman Paul Volcker — and even appears to widen its reach.

“The president has put the issue before us. The circumstances on the ground have put the issue before us,” as commercial banks are now tied in with “highly risky investment houses in a way that is inappropriate” for institutions that have taxpayer-backing, Merkley said.

“There is clearly a need for this legislation,” said Sen. Carl Levin (D-Mich.), the bill’s other lead sponsor.

That’s a very different message than Dodd or his top Republican negotiators, Bob Corker of Tennessee and Richard Shelby of Alabama, who’ve both questioned the need for the rules. Dodd himself has been less than enthusiastic, telling POLITICO when the White House sent up its language last week, “We’re going to write the bill here.”

The Obama administration proposal is widely expected to be left out of the bill Dodd hopes to unveil in the coming days.

The Merkley-Levin legislation also embraces President Barack Obama’s call for curbing the size of the nation’s financial behemoths, requiring large, interconnected nonbank financial firms to keep more capital on hand and ultimately place a firm ceiling on their size, Merkley told reporters on a conference call Wednesday.

Like the White House proposal, taxpayer-backed banks would be prohibited from investing in or owning hedge funds and private equity funds.

Joining Merkley and Levin in supporting the Obama administration’s push for these rules are Sens. Sherrod Brown (D-Ohio), another member of the banking committee; Ted Kaufman (D-Del.) and Jeanne Shaheen (D-N.H.).

Merkley and Brown were among those Democrats who expressed strong concerns about another concession Dodd is making to Republicans: housing a new consumer watchdog in the Federal Reserve, which has been widely criticized for failing to use its existing consumer protection powers to curb predatory lending practices — especially out-of-control subprime mortgage lending — in the lead up to the financial crisis.

Senate hearing on prop trading - Feb 2, 2010

Hearing: Tuesday, February 2, 2010 , 02:30 PM 538 Dirksen Senate Office Building

The witness will be:

  • The Honorable Paul Volcker, Chairman of the President’s Economic Recovery Advisory Board, Testimony
  • Deputy Secretary of the Treasury Neal S. Wolin, Testimony

Senate hearing on "Volcker rule" - Feb 4, 2010

Thursday, February 4, 2010, 10:00 AM 538 Dirksen Senate Office Building

The witnesses will be:

  • Mr. Gerald Corrigan, Managing Director, Goldman Sachs;
  • Professor Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, Sloan School of Management, Massachusetts Institute of Technology;
  • Mr. John Reed, Former CEO, Citigroup;
  • Professor Hal Scott, Nomura Professor of International Financial Systems, Harvard Law School;
  • Mr. Barry Zubrow, Executive Vice President, Chief Risk Officer, JPMorgan Chase.

Volcker says give up bank charter if prop trading

Goldman Sachs and other banks should give up their bank status if they want to avoid the ban on proprietary trading proposed by the White House, Paul Volcker, head of President Barack Obama’s Economic Recovery Advisory Board, said.

“The implication for Goldman Sachs or any other institution is, do you want to be a bank?” Mr Volcker said in a video interview with the Financial Times. “If you don’t want to follow those [banking] rules, you want to go out and do a lot of proprietary stuff, fine, but don’t do it with a banking licence.”

Markets are wondering how the rule would affect groups such as Goldman Sachs and JPMorgan Chase, which have proprietary trading desks and private equity units. The two groups also enjoy financial holding company status and the consequent right to borrow money from the Federal Reserve and accept retail deposits.

Institutions that give up their bank status to continue proprietary trading would lose “the special privileges of a bank”. “Don’t expect the support you would get from being a bank within the club of insured deposits and access to the Federal Reserve and all the loving attention you get as a bank organisation,” Mr Volcker said.

Goldman declined to comment but executives say that if the Volcker Rule is passed, it would probably sell its deposit-taking bank, which is an insignificant part of Goldman’s $900bn-plus balance sheet.

However, Goldman leaders do not believe they would have to give up the financial holding company status acquired at the height of the 2008 crisis to escape the rule’s ban on in-house trading.

Mr Volcker said giving up bank status would not allow financial institutions to “escape from all oversight and regulation . . . you’re going to be subject to some capital restraints, some leverage restraints, liquidity provisions”.

He argued that a key to drawing this distinction between banks and non-banks would be the creation of a robust “resolution authority” with the power and resources to take over and close down a non-bank. “The whole point of this is importantly to get at the moral hazard problem . . . these non-banks, if they get in trouble, are not going to be saved. Their creditors can’t sit there and say, I’m going to be protected. The management can’t expect to stay in office. The stockholders can expect to lose.”

Mr Volcker said the resolution process for non-banks would be “euthanasia rather than life support and that’s a big difference”. He said the US should press ahead with the Volcker Rule unilaterally if necessary, but that a consensus on the plan between the US, UK, Germany and France was both preferable and achievable.

Merkley writing legislation to implement Volcker rule

"A member of the U.S. Senate Banking Committee said on Friday he is writing legislation that would apply more widely a White House proposal to limit risky investing, extending the reach to nonbank financial institutions as well as to banks.

Jeff Merkley, a a first-term Democrat from Oregon, said in a letter to colleagues that his bill would apply to nonbank financial institutions large enough to be "systemically critical."

The bill would broaden a proposal made last month by the White House known as the Volcker rule, because it was backed by Paul Volcker, an economics adviser to President Barack Obama and a former chairman of the U.S. Federal Reserve.

The Merkley bill would prohibit these firms "from owning or operating hedge funds and private equity funds and from engaging in proprietary trading," or using their own capital to pursue above-market returns unrelated to customer needs.

Merkley said the limits would curb "taxpayer-backed gambling" of the sort pursued by major investment and commercial banks in the run-up to the financial crisis of 2008 and 2009 that shook markets worldwide, leaving many institutions backed by taxpayers.

"Reasonable market-making, underwriting and risk management activities should still be permitted, as long as they are not used as a backdoor means to place bets on volatile and illiquid assets," Merkley said in the letter...."

Dodd calls Obama plan too grand

The chairman of the Senate Banking Committee warned on Tuesday that the Obama administration’s new proposals to rein in Wall Street firms ran the risk of derailing months of delicate negotiations over overhauling financial regulations.

“It’s not a movable feast,” the chairman, Christopher J. Dodd, told Paul A. Volcker, the former Federal Reserve chairman, who has become an influential outside adviser to President Obama. “It’s adding to the problems of trying to get a bill done,” he said at the end of a hearing on the proposals, after all the other committee members had already left.

Mr. Dodd, Democrat of Connecticut, added that the administration was “getting precariously close” to excessive ambition for the legislation. “I don’t want to be in a position where we end up doing nothing because we tried to do too much,” he said.

The hearing was the first formal Capitol Hill discussion of Mr. Obama’s two proposals. One would ban banks that use federal deposit insurance and the Federal Reserve’s discount window from engaging in proprietary trading — making market bets using their own money. They also would not be able to own hedge funds and private equity funds. The other would seek to bar further consolidation among financial institutions by capping the future size of any firm.

Both ideas have factored into a debate over how to prevent banks from becoming so large and interconnected that they are too big to fail, posing systemic risk to the financial system and requiring a government bailout if they falter.

Dodd supports the "Volcker rule"

"... “The Obama administration has proposed bold steps to make the financial system less risky. We welcome those ideas.”

“The first would prohibit banks – or financial institutions that contain banks – from owning, investing in, or sponsoring a hedge fund, a private equity fund, or any proprietary trading operation unrelated to serving its customers. The President of the United States has called this the ‘Volcker rule,’ and today Chairman Paul Volcker himself will make the case for it.”

“I strongly support this proposal. I think it has great merit.”

“The second would be a cap on the market share of liabilities for the largest financial firms, which would supplement the current caps on the market share of their deposits.”

“I think the administration is headed in the right direction with these two proposals.”

“I know the timing of them - how they have been proposed at a critical time when we have been deeply engaged in this committee on reforming the financial services sector - may have raised a few eyebrows. But I think we need to get past that, if we can, and think about the merits of these ideas and how they would work if they could be put in place. And so I welcome the conversations we are going to have today and later this week on these issues.”

“These proposals deserve our serious consideration, and so today we will hear from Chairman Volker and Deputy Secretary Wolin, and on Thursday we will hold another hearing with business and academic experts.”

“These proposals were borne out of fear that a failure to act would leave us vulnerable to another crisis, and of frustration at the refusal of financial firms to rein in some of these more reckless behaviors.”

“I share that fear, and I share that frustration. And I strongly oppose those who argue that the boldness of these proposals is out of scale with the need for reform.”

“We need to take action, and we must consider scaling back the scope of activities banks may engage in while they are using deposits.”

“And so today I look forward to hearing how these proposals may be most effectively applied to protect consumers and our economy and also – playing the devil’s advocate - why these ideas may not work, and what risks they might pose if adopted.”

“Some have objected to the Volcker rule on the grounds that it might not have prevented the crisis, or that these particular limits are unwise. I think those objections are worth discussing and I am interested in giving our witnesses and our colleagues here a chance to raise these items and a chance to have a vibrant and robust debate about them.”

“But we must take steps to change the culture of risk-taking in our financial sector, including the management and compensation incentives that drove so much of the bad decision-making.”

Dodd, Shelby, Warner against "Volcker rule"

A proposal by former Federal Reserve Chairman Paul Volcker to limit bank’s proprietary trading will be either be dropped or significantly modified in the Senate, lawmakers and staffers told dealReporter.

Senate Banking Committee ranking member Richard Shelby (R-AL) said he opposes the so-called Volcker rule and the Obama administration’s call to levy a USD 90bn tax on banks. His comments come as House Financial Services Committee Chairman Barney Frank (D-MA) predicted the proposals outlined by President Obama could be law within six months.

Speaking to this news service on Thursday, Shelby said if Democrats push forward with the proposals they risk unravelling much of the bipartisan support already reached regarding the passage of financial regulatory reform in the Senate. Shelby said that the Obama administration risks losing Republican support for the bill if they begin to “politicise” the issue.

However, Shelby said he expects to hold a meeting with Banking Committee Chairman Chris Dodd (D-CT) regarding the way forward on regulatory reform in two weeks time. A Democratic banking committee staffer confirmed that the meeting between Dodd and Shelby will be critical as Dodd needs to determine the level of bipartisan agreement and the timing of bringing the bill through committee and on the Senate floor.

With the election of Republican Scott Brown to the Senate, the Democrats no longer have the necessary 60 votes to force through a Regulatory Reform package, and any bill will need at least some Republican support to pass. A Dodd staffer said the senator is likely to quietly drop or modify many of the recommendations in the Volcker rule to ensure Republican support for regulatory reform.

“Chris is retiring so he wants to end his career with an important regulatory reform bill and he wants to make the bill bipartisan,” the staffer said. “He is not going to risk bipartisan support to make the White House happy.”

The Democratic staffer said there is an ongoing debate among members of the banking committee about whether the Volcker rule would effectively push risk out of regulated markets and thus ultimately create more risk to the financial system.

Dodd told this news service on Thursday that the banking committee will begin mark-up of the financial regulatory bill in the near future and his committee will hold a committee meeting on the Volcker Amendment on Tuesday with Volcker and a follow-up hearing on Thursday.

Senator Mark Warner, a Democrat on the banking committee from Virginia, also said he has concerns regarding elements of the Volcker rule, many of which are already being dealt with by the committee. He said that one of the problems is in the definition of what constitutes proprietary trading and that regulators should be more proactive in determining what constitutes excessive risk taking by financial players.

Warner also said that the prospective Senate version of the Kanjorski amendment passed by the House also includes using capital adequacy standards to reign in excessive risk taking by financial institutions and that such an approach gives regulators greater flexibility.

A Democrat committee staffer said the Senate committee is loathe to include statutory capital adequacy standards included in the House bill and that such standards should be determing by regulators.

House Financial Services Subcommittee Chairman Paul Kanjorski told this news service he is only 80% to 85% in agreement with the Volcker rule and that many issues raised by Volcker are already included in his amendment passed by the House.

Warner blamed much of the political storm connected to regulatory reform on bankers. He called Goldman Sachs’s proposal to lend USD 500m to small businesses over a five-year period derisory, and said banks need to come out in front of the issue regarding compensation.

Warner said he is proposing that US banks set up a USD 1trn fund to invest in US infrastructure projects as a way to avoid the USD 90bn bank levy. A staffer said that Warner is not calling for the banks to place USD 1trn in cash, but to raise such an amount through leverage.

Global responses

EU finance ministers to resist Volcker plan

European Union finance ministers are uniting to oppose President Barack Obama’s proposal to limit banks’ size and risk-taking, saying his plan may run counter to EU policy, according to a draft document.

Their position, which they will ratify at a two-day meeting starting today, comes after Obama last month urged the adoption of the so-called “Volcker rule,” named for former Federal Reserve Chairman Paul Volcker. The plan would bar commercial banks from owning hedge funds and limit how much they can trade for their own account.

The finance officials gathering in Brussels will express “their concern that the application of the ‘Volcker’ rule in the EU may not be consistent with the current principles of the internal market and universal banking,” the document obtained by Bloomberg News said. “Any policy choice should avoid pushing risks to other parts of the financial system.”

The resistance underscores political divisions over how to overhaul banking regulations to prevent a repeat of the crisis that forced taxpayers to prop up the financial system. While leaders have called for a Group of 20 initiative, the U.S., Britain, and France are forging their own policies to limit compensation and risks.

At a meeting this month in Canada, Group of Seven finance ministers signaled they are rallying around a plan to introduce a levy on banks if it can be applied worldwide.

The Feb. 10 draft, entitled “Issues note on the most recent proposals of the U.S. administration in respect of Systemically Important Financial Institutions and the introduction of a financial crisis responsibility fee,” was prepared by a committee of officials from finance ministries, the European Central Bank and the European Commission.

The three-page memo also considered proposals including levying a stability fee on banks and creating national or pan- European funds for future bailouts.

UK Myners says best curb for prop trading is increasing capital charges

"...Myners reiterated Britain’s view that copying a plan by Obama to restructure and curb the size of big banks was not the best way to make the financial system safer.

Known as the Volcker rule after its architect, Paul Volcker, Obama’s plan would mean big banks with insured deposits divesting themselves of hedge funds, private equity and proprietary trading, or trading for their own account.

“I am not persuaded that the focus on hedge funds, private equity addresses the core issues that were at the heart of the global banking crisis,” Myners said.

“Proprietary trading is an issue but is best addressed by capital which Volcker actually concludes. My view is size is a less significant issue to focus on than interconnectedness,” Myners said.

A global agreement forged by the Basel Committee will introduce much higher capital charges on risky bank trading activities from January 2011.

Obama’s plans are part of a debate on how to tackle banks whose failure would destabilise markets but it is unclear if it will pass through Congress. [ID:nLDE61202H]

Germany, France and Britain have signalled they won’t follow suit, raising concerns about banks coming to Europe to conduct their risky activities. EU finance ministers are due to discuss the plans later this month. [ID:nLDE6111TJ]

Financial Stability Board does not endorse Volcker plan

The proposals announced by the US yesterday are amongst the range of options and approaches under consideration by the Financial Stability Board (FSB) in its work to address the moral hazard risks posed by too big to fail (TBTF) institutions.

This work, which began last fall, will result in recommendations to G20 Leaders in October 2010. The FSB will publish an interim report on this work shortly after the June G20 Summit.

Several other options for addressing the TBTF problem are being considered by the FSB.

These include: targeted capital, leverage, and liquidity requirements; improved supervisory approaches; simplification of firm structures; strengthened national and cross-border resolution frameworks; and changes to financial infrastructure that reduce contagion risks.

A mix of approaches will be necessary to address the TBTF problem, given the different types of institutions and national and cross-border contexts involved. At the same time, these approaches must preserve an integrated financial services market and not create regulatory arbitrage through an uneven playing field.

Work on the individual options is being carried out by the FSB’s Standing Committee on Supervisory and Regulatory Cooperation and by its Working Group on Cross-border Crisis Management, the Basel Committee on Banking Supervision, the Committee on Payment and Settlement Systems, and by IOSCO.

OECD highlights "separation issue"

Yesterday, Angel Gurría, Secretary-General of the Organsiation For Economic Co-Operation and Development stated that President Obama’s "separation plan" to place new restrictions on the size and scope of banks and other financial institutions in an effort to control excessive risk taking and protect taxpayers could, subject to clarification of "issues of timing and details about corporate structure," help to "avoid a new financial crisis by resolving some major risks inherent to the current financial system."

Secretary-General Gurría noted that the main prudential issue is "not so much the size of banks but the nature of what they do—the separation issue." In particular, the origins of the crisis can be traced to a shift from "the credit culture of commercial banking towards an equity culture focused on generating profits for shareholders and management by exploiting new financial innovations and leveraging them while taking advantage of regulatory and tax loopholes." Looking ahead Secretary-General Gurría stated the "separation plan" would help "significantly reduce contagion risk," "reduce counterparty risk," and "help sustainable growth by focusing management attention on the core needs of bank clients without major distractions and disruptions."

Darling warns Obama over banking reforms

Alistair Darling warns today that President Barack Obama’s proposals for shaking up the banks would not have prevented the crisis and risk undermining the international consensus on reforming the financial system.

In an interview with The Sunday Times, the chancellor made clear that he saw serious shortcomings in the American approach.

“It is always difficult to say ex ante that you would never intervene to save a particular sort of bank,” he said. “In Lehman, for example, there wasn’t a single retail deposit, but the then American administration allowed it to go down and that brought the rest of the system down on the back of it.

“You could end up dividing institutions and making them separate legal entities but that isn’t the point. The point is the connectivity between them in relation to their financial transactions.

“Equally, the large-small thing doesn’t run. Northern Rock was very small in global terms but systemically it was quite important when it got into trouble.”

The chancellor said Britain would continue to work with America on financial reform but that any proposals would have to be “workable and deliverable” and that he would not do anything to “disadvantage London relative to the rest of the world”.

Darling’s big worry is that Obama’s bombshell proposals, based on ideas set out last year by Paul Volcker, former chairman of the Federal Reserve Board, will shatter the consensus within the G20 nations on banking reform.

“If everyone does their own thing it will achieve absolutely nothing. The banks are global — they are quite capable of organising themselves in such a way that if the regime is difficult in one country they will go to another one, and that doesn’t do anyone any good.”

Lord Myners, the City minister, will host a meeting at 11 Downing Street tomorrow to discuss long-term solutions to the “too-big-to-fail” dilemma.

He is gathering senior representatives from each of the G7 nations, along with officials from the International Monetary Fund, the Bank of England and the Financial Services Authority.

Myners convened the meeting to discuss the best way to ensure banks will not need taxpayer bailouts in any future crisis. One plan is to force them to pay into a global insurance fund that could support the sector in times of stress. Another is a tax on all financial transactions, known as a Tobin tax.

Some of Wall Street’s biggest banks are examining ways to duck out of the restrictions. Goldman Sachs and Morgan Stanley are believed to be in talks with the US Treasury about changing their legal status to avoid the new rules.

Obama plan hinges on definition of client trades

"President Obama’s plan to curb risk- taking by banks hinges on how rigidly regulators define proprietary trading at firms such as Goldman Sachs Group Inc. and JPMorgan Chase & Co.

Goldman Sachs, which generated at least 76 percent of 2009 revenue from trading and principal investments, gets the “great majority” of transactions from customers, according to Chief Financial Officer David Viniar. About “10-ish percent” of the New York-based firm’s revenue comes from “walled-off proprietary business that has nothing to do with clients,” he said on a conference call yesterday.

The plan to curb proprietary trading at banks is among proposals that Obama said yesterday will strengthen the U.S. financial system and help prevent a repeat of the credit crisis. Other restrictions would prohibit banks from investing in hedge funds and private companies and put new limits on banks’ borrowings, according to the White House.

JPMorgan, Goldman Sachs, Citigroup Inc. and Bank of America Corp. tumbled more than 4 percent in New York trading yesterday, leading the S&P 500 Financials Index down 3 percent, its biggest decline since October. All the banks are based in New York except for Bank of America, which is in Charlotte, North Carolina.

Volcker’s Push

The White House defines proprietary trades as those not done for the benefit of customers, according to a senior administration official. Regulators would have the power to ask banks whether certain trades are related to client business, the official said. If they’re not, the regulators could order firms to exit the positions.

At banks such as Goldman Sachs, drawing the line isn’t easy, Viniar said.

“If a client wants to sell us a security, we’ll buy the security,” Viniar said. “That risk, which is principal risk, ends up on our balance sheet. It’s the great bulk of what we do all day long in all of our products for all our clients.”

Obama also proposed expanding a 10 percent cap on banks’ market share of deposits to curtail increases in liabilities. He said he wants to protect taxpayers from further bailouts, such as those provided through the $700 billion Troubled Asset Relief Program, passed under former President George Bush in late 2008. Obama voted for the program.

Obama said he wants to make sure banks don’t “benefit from taxpayer-insured deposits while making speculative investments.” He stopped short of calling for a reinstatement of the Depression-era Glass-Steagall Act, which before its repeal in 1999 banned the mixing of commercial banking and securities business..."

Proposals seek to "ring fence" deposits only

  • Source: Stage Prop The Economist, January 28, 2010

Technicalities matter, however, and Mr Obama's proposals do not live up to their billing. To talk, as some commentators have done, of a new Glass-Steagall act, the Depression-era law that split commercial and investment banking until the 1990s, is wildly off the mark (see article[1]). The administration seems to define proprietary trading narrowly, as the stand-alone "prop desks" most banks have for betting their own money (anything broader would be unworkable). It's easy to see why they do not deserve a public subsidy. It's hard to see why banning them makes banks much safer. Prop desks are a small part of most firms' activities and the same is true of banks' investments in private equity and hedge funds. These activities did not play a leading role in the crisis.

The proposals also betray a desire to ring-fence deposit-taking firms and let everything else fry. However understandable, the reality is that investment banks, credit-card operators, insurers and even carmakers' finance arms had to be bailed out. The system was too interconnected. The administration says that if a firm wants to continue prop trading (as Goldman Sachs might) it will lose the privileges banks get, such as federal deposit-insurance and access to the Federal Reserve's discount window. So what? Changing the label and culling symbolic perks would not make a firm less of a threat if it failed. As things stand the state would still have to step in.

The administration appears to have broken ranks with regulators elsewhere in the world. But in truth, like them, it is relying on new capital and liquidity buffers to do most of the work of making banks safer. For the average bank, these will probably succeed. But no one has yet found a convincing mechanism to deal with outliers whose losses in a typical crisis are far too great for any reasonable safety buffer. What is needed is a way of pushing losses onto creditors without sparking a run that endangers the whole system.

One option is to break banks into bits that can default without dragging down other firms. Mr Obama is being advised by Paul Volcker, a former chairman of the Fed and a fan of this approach. But a Glass-Steagall split, forcing commercial banks to ditch their investment-banking arms, is pointless if investment banks still have to be bailed out. And banks might have to be ground into gravel rather than just broken in two. The smallest firm subject to the Fed's stress tests in May had risk-adjusted assets of about $100 billion. If this were the minimum size of a systemically important firm, then America's four big banks would need to be split into 48 separate companies to be small enough to fail. American policymakers will be acutely aware that there is almost no appetite anywhere else, except Britain, for breaking up banks.

The alternative is to find ways to allow a controlled default of part of banks' balance-sheets. That will require the rejigging of their liabilities to include new forms of debt, as well as the creation of resolution authorities with enough power to impose losses on some creditors, but not so much that they terrify counterparties into running. That is a big task, which some banks will resist and which has been given no particular emphasis in the swamp of proposals being considered by Congress. If the president wants to keep his promises, this would be a good place to start.

New bank rules unlikely to hurt big institutions

President Barack Obama's latest broadside against big banks may have more bark than bite.

Obama's plan to limit banks' size and risky trading has spooked investors, but analysts say it would have only marginal effect on institutions like JPMorgan Chase, Bank of America and Citigroup _ and would be hard to enforce. And it's not clear the rules would reduce taxpayers' risk of having to bail out another big bank.

The White House has yet to provide details of the plan outlined Thursday. But attention has centered on Obama's effort to bar the biggest banks from doing what's called proprietary trading. That's when banks use their own money to make high-risk bets. If those bets go bad and a bank goes under, taxpayers could be on the hook.

Fearing the Obama plan might reduce bank earnings, investors reacted by dumping financial stocks Thursday, helping send the Dow Jones industrial average down 213 points. The pessimism continued Friday, with the Dow losing more than 216 points. Also weighing on the market were corporate earnings reports that failed to meet investors' expectations.

The proposed overhaul marked Obama's latest effort to more tightly police the nation's largest banks. Last week, the president proposed a tax on banks to recoup billions in bailout money that was handed out at the height of the financial crisis in 2008.

The moves come as banks face increasingly hostile rhetoric from Obama. The president has called bankers "fat cats" and vowed to defeat the banking industry's lobbying efforts against financial reforms.

Still, several analysts called Wall Street's reaction to the latest proposals overkill.

One reason is that most big banks derive only a tiny fraction of their revenue from proprietary trading. At JPMorgan Chase & Co. and Bank of America Corp., for instance, proprietary trading brings in 1-2 percent of revenue, according to a Citigroup report. Less than 5 percent of Citi's revenue comes from proprietary trading. The figure is 3-4 percent for Morgan Stanley and less than 1 percent at Wells Fargo & Co.

"Proprietary investment restrictions probably won't have a huge impact on most banks," said Douglas Elliott, fellow at Brookings Institution and a former investment banker. "That's a pretty small part of what banks do."

Elliott said much will depend on how lawmakers write the legislation, which has yet to be put even in draft form.

Citing banks' limited proprietary trading activity, Citigroup analysts Keith Horowitz and Ryan O'Connell said in a note that the effect of Obama's proposal "may be less severe than expected."

The banking industry has reacted sourly to Obama's proposal. Edward Yingling, president and CEO of the American Bankers Association, said his members are "very concerned" about it.

One worry is how the limits on a banks' size would affect their competitiveness against large foreign rivals like Barclays PLC, Royal Bank of Scotland and Deutsche Bank. Of the biggest 50 banks in the world by assets, only six are U.S.-based, Yingling said.

"We've been a world leader in financial services, and we need to be very careful about doing something to undermine that," he said.

Several U.S. banks said they need more details of Obama's plan before they assess its effect. Bank of America said it's already acted to scale back risk. That includes no longer issuing complex financial products known as derivatives, spokesman Scott Silvestri said.

At Wells Fargo, proprietary trading "is a non-issue," spokeswoman Julia Tunis Bernard said.

"Products and services that help our customers succeed financially are core to our business, not risky proprietary trading," she said. Obama's proposal would also prevent banks that take federally insured deposits or that borrow from the Federal Reserve from owning or investing in hedge funds or private equity groups. That raises questions about JPMorgan's ownership of Highbridge Capital, a London-based hedge fund that manages more than $20 billion. The fund, however, is funded solely with client money. So it's unclear what effect Obama's proposal would have on the bank.

JPMorgan declined to comment.

Some banks would be affected more than others. Goldman Sachs Group Inc., for example, has long been among the most aggressive trading firms on Wall Street. On Thursday, Goldman reported a $4.79 billion quarterly profit, the biggest three-month gain since the bank went public in 1999 and one generated largely from risky trading in bonds, commodities and currencies.

Proprietary trading accounts for roughly 10 percent of Goldman's yearly revenue. That works out to $4.5 billion based on the company's 2009 performance. Adjusted for expenses, the new rules could, in theory, cost Goldman $1 billion in annual profit, according to the Citigroup report.

David Viniar, Goldman's chief financial officer, downplayed the impact of the new rules, calling proprietary trading "a very small part" of Goldman's business.

Other analysts warn Obama's proposal could cause serious damage to banks. Meredith Whitney, an analyst who predicted much of the industry's tumult in recent years, said the new rules could hammer banks' trading profits.

"Our bet: This goes through, and it will not be pretty for banks or consumers," Whitney said of Obama's proposal in a report.

Enforcing the restriction on proprietary trading could be difficult. That's because defining which trades are proprietary and which aren't isn't always clear, said Daniel Alpert, managing partner at the investment bank Westwood Capital LLC, which invests in banks.

"Banks buying and selling securities is just like anybody who buys and sells inventory," Alpert said.

He said banks can buy securities they intend to sell to clients but sometimes hold them because there isn't enough demand.

A big question is whether the proposed rules would make the financial system _ and by extension U.S. taxpayers _ safer.

Scott Talbott, chief lobbyist for the Financial Services Roundtable, a trade group whose members include the largest banks, said restricting proprietary trading could do more harm than good by limiting banks' ability to reduce or offset risk.

"You're eliminating a tool in the arsenal to manage risk," Talbott said. By doing so, "the banks are going to be more at risk, and that's not the goal right now."

Others say Obama's proposal doesn't go far enough.

John Boyd, a finance professor at the University of Minnesota, said the financial crisis had many causes beyond trading _ including the repackaging of mortgages and banks taking on so much risk that they nearly collapsed the system.

"If all we're talking about is limiting proprietary trading, it's simply not adequate," he said. "The fundamental problem is too big to fail, and until that's dealt with in a serious way, we're going to have problems."

Using transparency to develop jurisdictional boundaries

"...As it becomes increasingly easy to move capital around the world, global regulatory arbitrage is an ever increasing risk in substantive regulation. One advantage of regulation requiring more disclosure, relative to regulation that sets substantive limits on certain business activity (voluntary or mandatory) is that disclosure regulation can help jurisdictions that adopt it become more, not less competitive.

The number of warheads is less important than the ability to verify and trust the final count. Better information results in better markets. Therefore, investors typically prefer markets with stronger information ecosystems – the U.S. market for public company securities, the world’s strongest capital market, being Exhibit 1.

Giving companies flexibility to arrange their finances as they see fit – as long as all material information is fully and accurately disclosed according to industry standard accounting policies – has repeatedly proven more successful than command and control. Using effective disclosure technology may diminish profits for particular firms as economic rents are competed out of a particular market, but unlike parochial limitations that help incumbent firms protect their franchises and create barriers to entry for potential competitors, disclosure regulation helps the customers of regulated entities get closer to the balance of risk and reward that they ultimately wish to achieve – and helps these customers do so at lower prices.

Neither SOX nor XBRL, of course, applied to asset-backed securities disclosure, since the securities were issued as separate instruments through special purpose vehicles rather than public companies.

The public companies that traded ABS generally complied with SOX insofar as implementing internal controls over their U.S. GAAP reporting. It is a commonplace that few anticipated the financial crisis, but some investors saw beyond mere SOX compliance.

These investors paid to convert ABS data from its unstructured ASCII and HTML format available under Reg. AB into structured formats that could be analyzed in spreadsheets.9 As the SEC simultaneously developed other uses for XBRL, EDGAR Online, Inc., a leading U.S. financial software firm, used XBRL to analyze residential mortgage-backed securities (RMBS) for clients well before the crisis became acute. In spring 2007, Wired magazine reports,10 two hedge funds asked EDGAR Online, which had experience parsing document based GAAP disclosures for public companies, to do the same for RMBS.

Because RMBS disclosures to the SEC were made in ASCII and HTML, not a business-specific standard, the company had to assign “four engineers to categorize and standardize the… contents―creating a Rosetta stone that could translate the 600 unique, inconsistent fields into 100 uniform categories.”

According to Wired, after the engineers delivered the results of their findings, the hedge funds “saw…a nationwide crisis in the making – as adjustable-rate mortgage rates ballooned, countless home-owners would default on their loans, rendering the securities built on them worthless.”

Transparency – for those who paid for it in this case – completely changed the financial battlefield. The message to those who paid for the information was clear: Short mortgage-backed securities and anything that depends on them.

The sophisticated investors who paid to structure RMBS data in XBRL obviously had better information about their investments than the putatively “sophisticated” investors who only had old-fashioned ASCII and HTML to help them with their due diligence.

Like modern warfare that increasingly depends on the surveillance and speed of satellites, faster and better knowledge of the RMBS changed the terms of competition in the markets.

Goldman Sachs Group CEO Lloyd Blankfein defended his firm in his January 13, 2010, testimony to the Financial Crisis Inquiry Commission (FCIC) on the basis that it only sold RMBS derivatives to “sophisticated” investors. The fact that many of these so-called sophisticated investors were unable to use the disclosures required by the SEC under Reg. AB speaks for itself. Mr. Blankfein may wish today that the sophisticated investors with whom he did business had better information, though Goldman Sachs and other participants might not have found the market for RMBS and their derivatives nearly as profitable.

On January 13, Mr. Blankfein found himself defending his firm for hedging its asset-backed securities derivatives – what critics have called betting against some of its clients. Similar conflict of interest challenges exist in public company markets, but industry standard GAAP format disclosures help manage that risk effectively by leveling the information playing field. The FCIC will explore why simple securities based on large pools of future flows of funds from individual borrowers – considerably simpler to value than the debt or equity securities issued by public companies – led so many to accept so much hidden risk. The FCIC should determine why complex instruments designed to manage that risk failed, and why disclosure might have been poor in the first place, leading to the development of more complex instruments to manage unnecessarily hidden risk.

The SEC found in January 2005 that it was not practical to draft detailed disclosure guides for each type of asset-backed instrument that may be securitized. That was before the Commission understood the meaning of eXtensible, which makes it easy to customize disclosure for genuinely unique facts about particular securities while still tagging the information to make it as useful as possible to investors. With the experience of developing and updating the U.S. GAAP and other XBRL reporting systems, the technology is ready. Five years later, in January 2010, it is not only practical – it is essential to use XBRL to guide disclosure for asset backed securities.

Pundits on the Volcker rule

Five former Treasury Secretaries endorse Volcker plan

We who have served as secretary of the Treasury in both Republican and Democratic administrations write in support of the proposed legislation to prohibit certain proprietary activities of commercial banking organizations—the so-called Volcker rule, as part of needed financial reform ("It's Time for Financial Reform Plan C," by Alan Blinder, op-ed, Feb. 16).

The principle can be simply stated. Banks benefiting from public support by means of access to the Federal Reserve and FDIC insurance should not engage in essentially speculative activity unrelated to essential bank services.

Hedge funds, private-equity funds, and trading for speculative gains are activities carried out by thousands of nonbanking firms. These firms and funds are and should also be free to compete and to innovate. They should, like other private businesses, also be free to fail without explicit or implicit taxpayer support. Those few nonbank firms that present systemic risk should be subject to reasonable restrictions on capital, leverage and liquidity.

We fully understand that the restriction of proprietary activity by banks is only one element in comprehensive financial reform. It is, however, a key element in protecting our financial system and will assure that banks will give priority to their essential lending and depository responsibilities.

We urge the United States to take the lead in the forthcoming G-20 meeting and other appropriate forums to achieve broad agreement on this principle among the leading financial centers.


  • W. Michael Blumenthal
  • Nicholas Brady
  • Paul O'Neill
  • George Shultz
  • John Snow

Stiglitz on the bank plan

In the last two weeks, President Obama finally proposed tough new restrictions on the big banks, and then he underlined them in his State of the Union speech. It's a start.

The one thing economists agree on is that incentives matter. Unless incentives and constraints are changed through regulation, it is unlikely that behavior on Wall Street will change. And once again, our financial system, our economy and the taxpayer will be in jeopardy.

"Too big to fail" banks have a strong incentive to gamble: If they win, they walk away with the profits; if they lose, the taxpayer picks up the tab. The bailouts blindly saved big banks while smaller banks went bankrupt -- 140 in 2009 alone -- leading to an even more concentrated banking system.

The new rules the administration is proposing are not intended to punish the big banks but to create a sounder financial system. Because the big banks are, effectively, insured by the government, they have had a competitive advantage that isn't based on greater efficiency but on implicit subsidies and political connections. They are not only too big to fail, they are too big to manage; they are, in fact, too big to be.

Two weeks ago, Obama called for a new tax on the 50 largest U.S. financial institutions. The idea is to discourage excessive risk-taking, to re-balance a tilted playing field and to generate needed revenue.

Yet even if Congress goes along, it won't be enough. The executives who run these institutions are likely to force shareholders to bear the burden of the tax, while they just keep on much as before. Shareholders have already suffered as the executives undertook mergers, paid out bonuses and took other actions that have diminished shareholder value. Indeed, a new tax would give the bankers one more excuse not to restart lending.

On Thursday, Obama made a second, more direct proposal: to use regulations to restrict the way the big commercial banks operate, in order to curb their size, their risk-taking, their conflicts of interest and their ability to abuse the privileges afforded by access to government guarantees and funds through the Fed. Under this proposal, banks would not be allowed to run hedge funds or to engage in proprietary trading -- which is to say, they would not be able to use funds to trade on their own behalf. There was never a good justification for the commingling of these activities. Reinstating such restrictions won't diminish the ability of the financial system to provide key financial services, though without the implicit government subsidy, their costs may go up.

As always with regulation, however, the devil is in the details. Poorly written or inadequately enforced regulations cannot save the taxpayer or the economy from jeopardy. As important, these initiatives are just the beginning of what needs to be done. They don't solve the problem of derivatives, which caused AIG's implosion and cost $180 billion in taxpayer bailout funds. The administration says it plans to encourage the movement to an exchange-traded, standardized derivative market, to enhance competition and transparency in these complex, intertwined, high-risk investments.

But will these efforts, as well-intentioned as they may be, really work? If they don't -- if nontransparent, complex, nonstandardized over-the-counter trading by the too-big-to-fail institutions continues -- the danger of creating another too-intertwined-to-fail situation remains palpable. Enhanced competition and transparency will lower risks -- but it will also lower the big banks' profits. Moreover, so far there is little assurance that the exchanges will be adequately capitalized -- we may simply create a need for another massive bailout.

A better solution is to bite the bullet. It makes no sense for the government to underwrite these risks. The big banks should not be allowed to trade in these products, and those who participate in the derivatives market should be made to pick up the tab for any losses their trades incur, without the option of turning to the government. The derivatives market would no doubt shrink; it thrives today partly on the basis of the implicit government subsidy.

If we allow the big banks to continue operating as they have been, they could once again hold the country hostage in a time of crisis, combining their favorite weapon -- fear -- with their political clout to extract money from the rest of us.

Well-written, enforceable regulation, combined with making the financial sector pay its own way, hold the prospect of redirecting Wall Street's creative energies. Perhaps it will then do a better job in its core functions of managing risk, allocating capital and running an efficient, sound payments system.

Obama's proposals are only a good beginning.

Skidelsky on bank reform

"...Moreover, many countries with integrated banking systems did not have to bail out any of their financial institutions. Canada’s banks were not too big to fail – just too boring to fail. There is nothing in Canada to rival the power of Wall Street or the City of London. This enabled the government to swim against the tide of financial innovation and de-regulation. It is countries like the US and Britain, with politically dominant financial sectors competing to take over financial leadership of the world, that suffered the heaviest losses.

This is the point that the well-intentioned regulators miss. At root, the battle between the two approaches is a question of power, not of technical financial economics. As Johnson pointed out in his Congressional testimony, “solutions that depend on smarter, better regulatory supervision and corrective action ignore the political constraint on regulation and the political power of big banks.”

Such proposed solutions assume that regulators will be able to identify excess risks, prevent banks from manipulating the regulations, resist political pressure to leave the banks alone, and impose controversial corrective measures “that will be too complicated to defend in public.” They also assume that governments will have to the courage to back them as their opponents accuse them of socialism and crimes against freedom, innovation, dynamism, and so on. In fact, this chorus of abuse has already started, led by Goldman Sachs Chairman Lloyd Blankfein.

There is another interesting parallel with the New Deal. Roosevelt got the Glass-Steagall Act through Congress within a hundred days of his inauguration. Obama has waited over a year to suggest his bank reform, and it is unlikely to pass. This is not just because the banking crisis in 1933 was greater than today’s crisis; it is because much more powerful financial lobbies now stand between pen and policy. If reformers are to win, they must be prepared to fight the world’s most powerful vested interest.

Kotlikoff says `Volcker Rule' won't do enough for banks

Laurence Kotlikoff, professor of economics at Boston University, talks with Bloomberg's Mark Crumpton about his proposed overhaul of the U.S. financial industry. President Barack Obama on Jan. 21 introduced a proposal he called the "Volcker Rule" to limit the size and trading activities of financial institutions and reduce risk-taking. Kotlikoff maintains the proposals won't do enough.

Wallison on bank commitments to real estate lending

"...There is one more factor to consider. Banks have been committing themselves increasingly to financing real estate. The reason for this is simple. Because they cannot underwrite or deal in securities, they have been losing out to securities firms in financing public companies—that is, most of American business other than small business. It is less expensive for a company to issue notes, bonds or commercial paper in the securities markets than to borrow from a bank.

Where, then, can banks find borrowers? The answer, unfortunately, is commercial and residential real estate.

Real-estate loans rose to 55% of all bank loans in 2008 from less than 25% in 1965. These loans will continue to rise in the future, because only real-estate, small business and consumer lending are now accessible activities for banks.

This is not a good trend, because the real-estate sector is highly cyclical and volatile. It was, indeed, the vast number of subprime and other risky mortgages in our financial system that caused the weakness of the banks and the financial crisis. Requiring banks to continue to lend to real estate, because they have few other alternatives, virtually guarantees another banking crisis in the future.

Since banks can never be let out of these restrictions as long as they are government-backed, one solution for banking organizations is to center their activities in the bank holding company which—because it is not government-backed—does not have to limit its range of activities. The fact that Mr. Obama now proposes to close off this one avenue through which banking organizations can be profitable is strong evidence that neither he nor his advisers, in attempting to lash out at banks, have thought through the long-term prospects and needs of the banking industry.

That might make good populist politics, but it is not responsible policy. Instead of trying to punish the banking industry, Mr. Obama should try to understand why banks have become so heavily invested in real estate.

Banks must remain restricted in their range of activities, but bank holding companies are not banks. The solution to the long-term problems of the banking business is not to narrow the activities of bank holding companies, but to broaden them."

Johnson - Off With Their Heads

"...Back-to-back international financial crises are rare, but the continued presence of such perverse incentives always leads to trouble – more than 50 years of IMF experience is clear on this point.

But, finally, after Massachusetts, it looks as if something important is happening. The reforms proposed by Volcker would impose restrictions on banks similar to those contained in the Glass-Steagall Act, the depression-era legislation that separated commercial banking and investment banking. The dilution of Glass-Steagall, and its ultimate repeal in 1999, allowed banks to engage in so-called “proprietary trading” – enabling them to use depositors’ savings to trade for their own account, mainly in risky mortgage-backed securities.

But the Obama administration must go further than prohibiting proprietary trading by commercial banks and do two further things. First, capital requirements should be tripled – not just in the US, but across the G-20 – so that banks hold at least 20-25% of assets in core capital. That way, shareholders rather than regulators would play the leading role in making banks behave sensibly.

Second, if banks are “too big to fail,” they must be shrunk, so that taxpayers do not need to bail them out every time a crisis erupts. In the US context, the Riegle-Neal Interstate Banking Act of 1994, which set a size cap so that no bank can have more than 10% of retail deposits, needs to be amended. We need to update and enforce this sensible general notion and set a limit on how big any bank can become relative to the overall economy.

Obama is right to get tough with the six largest US banks – including JP Morgan Chase, Goldman Sachs, Citigroup, and Bank of America – which now have total assets worth more than 60% of GDP. This is an unprecedented degree of financial concentration. As Teddy Roosevelt pointed out more than 100 years ago, concentrated economic power tends to take over political power, which runs counter to the democratic tradition. We have now learned that it also runs counter to sound economic policy."

Morgenson - Resetting the moral compass

"... The proposal has its weaknesses. In the pantheon of risk-taking at banks, it is hard to argue that proprietary trading involves substantially greater peril than that inherent in commercial lending. Just ask the banks that are sitting, nervously, on huge loans backed by commercial real estate that were made during the mania.

And some may wonder why the proposal’s spotlight is so trained on proprietary trading and hedge fund operations, since these were not where banks experienced their greatest losses in the crisis. The biggest money pits were a result of securities underwriting, especially in the mortgage arena. When the mortgage spree ground to a halt, firms like Lehman Brothers and Merrill Lynch were stuck with toxic securities they had underwritten but had been unable to persuade customers to buy.

Moreover, the entire financial system over the last two decades became linked in a potentially viral network of derivatives contracts that won’t go away simply because traders decamp to a different neighborhood than depositors.

Still, singling out proprietary trading, hedge funds and private equity units does make sense for a couple of reasons. First, the proposal moves us closer to resolving pieces of the “moral hazard” issue, that uncomfortable state of affairs that occurs when companies don’t worry about bet-the-ranch risks because they know that someone (usually the taxpayer) is waiting in the wings to save them if they blow it (as they so often do).

So reducing the number of ways in which banks can engage in morally hazardous activities is a positive move.

THERE is another morality problem that the Volcker plan would address: insider trading. Proprietary trading, hedge funds and private equity units are three lines of business where Wall Street firms can profit mightily on inside information and data gleaned from their customer relationships elsewhere in the company.

As financial firms have become more vertically integrated in the past 10 years, adding to their stable of businesses, the potential for profiting on nonpublic information has increased exponentially. Meaningful information can emerge from a client’s securities holdings, from pending transactions the client wants to make or from a firm’s knowledge of the customer’s financial standing.

Of course, banks maintain that they have built impenetrable walls in their organizations to prevent seepage of material information. But suspicions remain about the effectiveness of these barriers, and with good reason.

Even if the so-called Volcker Rule takes effect, it won’t do much to eliminate the fact that regulators and legislators will continue to see large financial institutions as too big or too interconnected to fail. Even if Goldman Sachs gave up its bank holding company status to escape new restrictions on proprietary trading, does anybody think the government wouldn’t bail it out if it gambled so poorly that it landed on the precipice?

And even if the new rules are put in place, it will be hard for regulators to differentiate between transactions that a bank makes for its clients from those made in its own account. In addition, you can be sure that armies of Wall Street lawyers are even now studying ways to circumvent such rules if they are enacted.

More troubling, said Christopher Whalen, editor of the Institutional Risk Analyst, is that the Volcker Rule would do nothing to solve the most disturbing problem to have emerged in the crisis: how Wall Street created flotillas of toxic securities and sold them to investors.

“We are tilting at stereotypes of what we think is the problem,” Mr. Whalen said. “But the bottom line is, we have prostituted our standards of securities underwriting and sales of securities to investors. When the Street starts justifying stuffing customers and saying, ‘It’s O.K., caveat emptor,’ that requires a public policy response. We need to say to the Street, ‘In all the things you do, especially if it is sold to a pension fund, you have a duty of care to every party in the transaction.’”

This seems quaint indeed, given the prevailing view on Wall Street that if a sophisticated investor buys a pool of poisonous mortgage loans, the seller has no obligation to keep the “big boys” from harm. But bringing a sense of duty back into the sale of securities to customers, regardless of their sophistication, is a worthy goal. And it is one that Wall Street should welcome if it hopes to regain investor confidence anytime soon."

Whalen on the Volcker plan

There are certain basic things that the investor must realize today. In the first place, he must recognize the weakness of his individual position… [T]he growth of investors from the comparative few of a generation ago to the millions of the present day has made it a practical impossibility for the individual investor to know what is occurring in the affairs of the corporation in which he has an interest. He has been forced to relegate his rights to a controlling class whose interests are often not identical to his own. Even the bondholder who has superior rights finds in many cases that these rights have been taken away from him by some clause buried in a complicated indenture… The second fact that the investor must face is that the banker whom tradition has considered the guardian of the investors' interests is first and foremost a dealer in securities; and no matter how prominent the name, the investor must not forget that the banker, like every other merchant, is primarily interested in his own greatest profit.

False Security: The Betrayal of the American Investor, Bernard J. Reis and John T. Flynn Equinox Cooperative Press, NY (1937)

Watching the President announcing the proposal championed by former Fed Chairman Paul Volcker to forbid commercial banks from engaging in proprietary trading or growing market share beyond a certain size, we are reminded of the reaction by Washington a decade ago in response to the Enron and WorldCom accounting scandals, namely the Sarbanes-Oxley law. The final solution had nothing to do with the actual problem and everything to do with the strange political relationship between the national Congress, the central bank and the Wall Street dealer community. We call it the "Alliance of Convenience."

The basic problems illustrated by the Enron/WorldCom scandals were old fashioned financial fraud and the equally old use of off-balance sheet vehicles to commit same. By responding with more stringent corporate governance requirements, the Congress was seen to be responsive -- but without harming Wall Street's basic business model, which was described beautifully by Bernard J. Reis and John T. Flynn some eighty years ago in the book False Security.

A decade since the Enron-WorldCom scandals, we still have the same basic problems, namely the use of OBS vehicles and OTC structured securities and derivatives to commit securities fraud via deceptive instruments and poor or no disclosure. Author Martin Mayer teaches us that another name for OTC markets is "bucket shop," thus the focus on prop trading today in the Volcker Rule seems entirely off target -- and deliberately so. The Volcker Rule, at least as articulated so far, does not solve the problem nor is it intended to. And what is the problem?

Not a single major securities firm or bank failed due to prop trading during the past several years. Instead, it was the securities origination and sales process, that is, the customer side of the business of originating and selling securities that was the real source of systemic risk. The Volcker Rule conveniently ignores the securities sales and underwriting side of the business and instead talks about hedge funds and proprietary trading desks operated inside large dealer banks. But this is no surprise. Note that former SEC chairman Bill Donaldson was standing next to President Obama on the dais last week when the President unveiled his reform, along with Paul Volcker and Treasury Secretary Tim Geithner.

Donaldson is the latest, greatest guardian of Wall Street and was at the White House to reassure the major Sell Side firms that the Obama reforms would do no harm. But frankly Chairman Volcker poses little more threat to Wall Street's largest banks than does Donaldson. After all, Chairman Volcker made his reputation as an inflation fighter and not in bank supervision. Chairman Volcker was never known as a hawk on bank regulatory matters and, quite the contrary, was always attentive to the needs of the largest banks.

Volcker's protégé, never forget, was E. Gerald Corrigan, former President of the Federal Reserve Bank of New York and the intellectual author of the "Too Big To Fail" (TBTF) doctrine for large banks and the related economist nonsense of "systemic risk." But Corrigan, who now hangs his hat at Goldman Sachs (GS), did not originate these ideas. Corrigan was never anything more than the wizard's apprentice. As members of the Herbert Gold Society wrote in the 1993 paper "Gone Fishing: E. Gerald Corrigan and the Era of Managed Markets":

"Yet a good part of his career was not public and, indeed, was deliberately concealed, along with much of the logic behind many far-reaching decisions. Whether you agreed with him or not, Corrigan was responsible for making difficult choices during a period of increasing instability in the U.S. financial system and the global economy. During the Volcker era, as the Fed Chairman received the headlines, his intimate friend and latter day fishing buddy Corrigan did "all the heavy lifting behind the scenes," one insider recalls."

The lesson to take from the Volcker-Corrigan relationship is don't look for any reform proposals out of Chairman Volcker that will truly inconvenience the large, TBTF dealer banks. The Fed, after all, has for several decades been the chief proponent of unregulated OTC markets and the notion that banks and investors could ever manage the risks from these opaque and unpredictable instruments. Again to quote from the "Gone Fishing" paper:

"Corrigan is a classic interventionist who sees the seemingly random workings of a truly free market as dangerously unpredictable. The intellectual author and sponsor of such uniquely modernist financial terms such as "too big to fail," which refers to the unwritten government policy to bail out the depositors of big banks, and "systemic risk," which refers to the potential for market disruption arising from inter-bank claims when a major financial institutions fails. Corrigan's career at the Fed was devoted to thwarting the extreme variations of the marketplace in order to "manage" various financial and political crises, a role that he learned and gradually inherited from former Chairman Volcker."

As Wall Street's normally selfish behavior spun completely out of control, Volcker has become an advocate of reform, but only focused on those areas that do not threaten Wall Street's core business, namely creating toxic waste in the form of OTC derivatives such as credit default swaps and unregistered, complex assets such as collateralized debt obligations, and stuffing same down the throats of institutional investors, smaller banks and insurance companies. Securities underwriting and sales is the one area that you will most certainly not hear President Obama or Bill Donaldson or Chairman Volcker or HFS Committee Chairman Barney Frank mention. You can torment prop traders and hedge funds, but please leave the syndicate and sales desks alone.

Readers of The IRA will recall a comment we published half a decade ago ('Complex Structured Assets: Feds Propose New House Rules', May 24, 2004), wherein we described how the SEC and other regulators knew that a problem existed regarding the underwriting and sale of complex structured assets, but did almost nothing. The major Sell Side firms pushed back and forced regulators to retreat from their original intention of imposing retail standards such as suitability and know your customer on institutional underwriting and sales. Before Enron, don't forget, there had been dozens of instances of OTC derivatives and structured assets causing losses to institutional investors, public pensions and corporations, but Washington's political class and the various regulators did nothing.

Ultimately, the "Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities" was adopted, but as guidance only; and even then, the guidance was focused mostly on protecting the large dealers from reputational risk as and when they cause losses to one of their less than savvy clients. The proposal read in part:

"The events associated with Enron Corp. demonstrate the potential for the abusive use of complex structured finance transactions, as well as the substantial legal and reputational risks that financial institutions face when they participate in complex structured finance transactions that are designed or used for improper purposes."

The need for focus on the securities underwriting and sales process is illustrated by American International Group (AIG), the latest poster child/victim for this round of rape and pillage by the large Sell Side dealer banks. Do you remember Procter & Gamble (PG)? How about Gibson Greetings? AIG, along with many, many other public and private Buy Side investors, was defrauded by the dealers who executed trades with the giant insurer. The FDIC and the Deposit Insurance Fund is another large, perhaps the largest, victim of the structured finance shell game, but Chairman Volcker and President Obama also are silent on this issue. Proprietary trading was not the problem with AIG nor the cause of the financial crisis, but instead the sales, origination and securities underwriting side of the Sell Side banking business.

The major OTC dealers, starting with Merrill Lynch, Citigroup (C), GS and Deutsche Bank (DB) were sucking AIG's blood for years, one reason why the latest "reform" proposal by Washington has nothing to do with either OTC derivatives, complex structured assets or OBS financial vehicles. And this is why, IOHO, the continuing inquiry into the AIG mess presents a terrible risk to Merrill, now owned by Bank of America (BCA), GS, C, DB and the other dealers -- especially when you recall that the AIG insurance underwriting units were lending collateral to support some of the derivatives trades and were also writing naked credit default swaps with these same dealers.

Deliberately causing a loss to a regulated insurance underwriter is a felony in New York and most other states in the US. Thus the necessity of the bailout -- but that was only the obvious reason. Indeed, the dirty little secret that nobody dares to explore in the AIG mess is that the federal bailout represents the complete failure of state-law regulation of the US insurance industry. One of the great things about the Reis and Flynn book excerpted above is the description of the assorted types of complex structured assets that Wall Street was creating in the 1920s. Many of these fraudulent securities were created and sold by insurance and mortgage title companies. That is why after the Great Depression, insurers were strictly limited to operations in a given state and were prohibited from operating on a national basis and from any involvement in securities underwriting.

The arrival of AIG into the high-beta world of Wall Street finance in the 1990s represented a completion of the historical circle and also the evolution of AIG and other US insurers far beyond the reach of state law regulation. Let us say that again. The bailout of AIG was not merely about the counterparty financial exposure of the large dealer banks, but was also about the political exposure of the insurance industry and the state insurance regulators, who literally missed the biggest act of financial fraud in US history. But you won't hear Chairman Volcker or President Obama talking about federal regulation of the insurance industry.

And AIG is hardly the only global insurer that is part of the problem in the insurance industry. In case you missed it, last week the Securities and Exchange Commission charged General Re for its involvement in separate schemes by AIG and Prudential Financial (PRU) to manipulate and falsify their reported financial results. General Re, a subsidiary of Berkshire Hathaway (BRK), is a holding company for global reinsurance and related operations.

As we wrote last year ('AIG: Before Credit Default Swaps, There Was Reinsurance', April 2, 2009), Warren Buffett's GenRe was actively involved in helping AIG to falsify its financial statements and thereby mislead investors using reinsurance, the functional equivalent of credit default swaps. Yet somehow the insurance industry has been almost untouched by official inquiries into the crisis. Notice that in settling the SEC action, General Re agreed to pay $92.2 million and dissolve a Dublin subsidiary to resolve federal charges relating to sham finite reinsurance contracts with AIG and PRU's former property/casualty division. Now why do you suppose a US insurance entity would run a finite insurance scheme through an affiliate located in Dublin? Perhaps for the same reason that AIG located a thrift subsidiary in the EU, namely to escape disclosure and regulation.

If you accept that situations such as AIG and other cases where Buy Side investors (and, indirectly, the US taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype "problems" that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles that caused losses to AIG and other investors.

Neither prop trading nor the size of the largest banks are the causes of the financial crisis. Instead, opaque OTC markets, deliberately deceptive structured financial instruments and a general lack of disclosure are the real problems. Bring the closed, bilateral world of OTC markets into the sunlight of multilateral, public price discovery and require SEC registration for all securitizations, and you start down the path to a practical solution. But don't hold your breath waiting for President Obama or the Congress or former Fed chairmen to start that conversation.


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