Earlier this week, the industry mounted a forceful campaign to put the Volcker Rule out of their misery. Unfortunately, most of the advocacy focused on changes that require a statutory rewrite – at best a long-odds prospect. Thus, we turn here to an instead-of for the Volcker Rule that, we think, meets the statute’s intent better than the pending inter-agency NPR and, at the same time, addresses the industry’s not-unreasonable need for a proprietary-trading regime with which compliance can be sensibly accomplished and meaningfully enforced.

For this solution, we are indebted to Stanford’s Darryl Duffie, who released a paper earlier this week on the morass that is the market-maker definition. Included in the paper is a suggestion that capital and liquidity standards better meet prudential needs than the convoluted prop-trading ban, an idea with so much appeal that it became a hot topic at the FinServ Volcker-Rule hearing just two days later. Building on the Duffie concept, we here discuss just how to make capital and liquidity rules work in the Volcker context. We do not go into detail on how this construct could be accomplished under current law — this is too complex a question with which to dabble (other than to say that we think a carefully-constructed regime could be designed to meet the law’s demands).

But, to the key question: how could prudential standards accomplish the Volcker Rule’s prop-trading ban? In summary, one would take the pending Basel II.5 rules and, as needed, rejigger them to meet Volcker’s broader goals. This could be done either through freestanding revisions to the II.5 rules already wending their complex way towards a final rule in the U.S. or, better, through design of a trading-book capital regime in the Basel context that addresses this issue. Global regulators have since embarked on a “fundamental” rewrite of the trading-book rules to go beyond the II.5 clean-up to posit a complete restructuring of market-risk capital. The goals here are an end to arbitrage between the trading and banking books and substantive improvements in the risk measures and stress-testing applied to trading exposures. Thus, the more prop-trading risk a bank took, the tougher the capital up to and including capital requirements that create a de facto prohibition.

Isn’t this just what Paul Volcker ordered? The goal of the Rule is often overlooked in the complex construct Congress enacted and, now, regulators are seeking to implement. But, it was pure and simple: to block banks from taking undue risk with depositors’ money by playing in the seemingly-speculative realm of proprietary trading. The problem starts with finding where that speculative realm in fact starts and stops. For example, why is trading in USG and GSE obligations left unfettered even though Kidder Peabody and Salomon bet the bank and lost on them just a few years ago? We know why the law is drafted to exclude these obligations, but we also know that this arbitrary distinction between permitted and banned prop-trading books will do little to solve Mr. Volcker’s problem. And, why are USG obligations seemingly risk-free and Canadian ones toxic? Obviously, this call is far off the real risk mark.

Far better, we think, would be to identify risks in the trading book and tell banks just how much regulatory capital they must hold to take them. When risks rise too high, then capital should sky-rocket and, voila, a prohibition is borne. Regulators have – belatedly, to be sure – figured out how to do this for credit risk, where capital can rise to dollar-to-dollar levels or even higher for positions regulators view with alarm. Again belatedly, the liquidity rules are now also penalizing banks for the privilege of borrowing short to lend long; a similar edifice of liquidity rules addressing trading-book liquidity can and should be deployed to ensure that all risk fronts are covered and, when necessary, that crossing them is prohibited.

What are the advantages of this alternative over the definitional daze caused by the pending NPR? First, the trading-book rules are already in the works, meaning that big banks have systems in place to handle them and – critically – examiners and investors know how to judge compliance. Second, the capital and liquidity rules are global ones that govern all big banks, not just U.S. ones. This addresses a critical failing of the Volcker Rule – applying it just to U.S. firms exacerbates global asymmetry, competitive disparities and shadow-bank risk. And, speaking of the shadows, a capital/liquidity regime for banks can and should be applied to nonbank broker-dealers – application easy to do in the U.S. under Dodd-Frank and also viable in the global context.

Perhaps we cozied up to the capital/liquidity alternative because we’ve spent so long in these trenches that we are all too comfy there. The counter to the capital/liquidity alternative is that regulators will again get it wrong and, thus, allow banks to bet their futures on high-flying trading. But, capital has become the bulwark of bank regulation – read the G-SIB surcharge rules and the FRB’s systemic NPR if any doubt remains. Why does capital work so well for credit risk in the banking book and, yet, still seem ill-suited for the trading book? And, if it’s so ill-suited to the trading book, why then still impose a capital regime for market risk?

This brings us back to our theme: complexity risk is the root of confusion, cross-cutting consequences and perverse incentives. If regulators trust capital, then rules should rely on it buttressed by other prudential safeguards, not on a pile-up of capital and safety-and-

soundness rules along with complex, ill-crafted activity prohibitions. If regulators don’t trust themselves with capital, then they should scrap the rules and go to the “narrow-banking” model on which the Volcker Rule is premised and follow suit with similar hard-wired bans for other high-risk activities. Either with or without capital as the cornerstone, the rules could make sense; with capital atop convoluted proposals, complexity will dictate confusion, leading to an incoherent construct that dooms meaningful compliance and real risk reduction.

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