Skeptics have greeted the monumental Volcker proposal by suggesting that big banks can leap over even this tall proposal in a single bound of daring regulatory arbitrage. But, we see a lot of kryptonite, and not just to banks that had hoped to cling to some proprietary trading and non-traditional investments. The draft is so tightly crafted that it will smother not just these once-lucrative businesses, but also the ability of complex banks to use proven hedges to limit risk in lending and all the other activities that make banks banks. And, along the way, the proposal does still more damage to asset securitization, reducing the already low-odds that secondary markets could resuscitate themselves to support an economic recovery.
How so? First, the rule would establish a set of awesomely-complex criteria for permissible hedges by which a bank would need to judge itself and, then, under which supervisors would second guess them. The rules are complex because the hedges can be similarly confounding, and regulators wanted to parse through all the hedges to pick out those that smacked of proprietary trading. Comments will judge the degree to which this is, in fact done, but our guess is that many essential risk-management hedges, especially at the largest banks, will be sanctioned.
This would come not just through direct prohibitions on specific hedging strategies, but also from the giant cloud of legal and reputational risk that hangs over the Volcker Rule as a whole. The proposal would subject banks to extensive internal-control and corporate-governance standards subject to significant external and senior-management scrutiny. This is reasonable – we’re fans of qualitative risk-management protocols – but the complexity of the proposal’s prohibitions will be hard to square with the rigor of these controls. When in doubt, a bank won’t do it. And, when it doesn’t do a needed hedge, its risk goes up, not down.
Another unintended consequence of the proposal is its impact on the emerging liquidity-risk management standards. These complex Basel III rules have lots of flaws, but their goal is vital: to address the liquidity risk that created Bear Stearns, Lehman and AIG and that now is doing the same for the entire EU financial system. But, one way to deal with liquidity risk is to hold large positions in highly-liquid assets that can be sold on short notice to meet unanticipated calls as well as used day to day to handle routine activities.
The fundamental nature of liquidity risk management means that banks are in and out of the liquid-asset holdings all the time to meet customer demand, rebalance their books in light of changing market conditions and – again – to hedge risk. The more regulatory risk attending a liquidity book, the less agile the bank will be in holding these assets and hedging their risk. Oops.
Finally, what does the rule do to securitization? Pretty much what it does to hedging and liquidity risk management – cast so deep a pall of regulatory risk over the activity that prudent banks will simply eschew it. For securitization, this pall comes not just in the wafts of legal and reputational risk created by Volcker. It’s compounded by one requirement in the proposal: any securitization position exempt from sanctions must comply with the Dodd-Frank risk-retention rule. And, what’s that? We’ve seen only a proposal to date and, like Volcker’s NPR, it was so preliminary with so many questions and footnotes that planning to comply with it is, for now, flat-out impossible.
It’s not that we think banks backed by all sorts of safety nets should be high-flying traders. They shouldn’t because, then, they are playing with other people’s money – fun, but not fair. But, the proposal is so complex in its efforts to catch banks at any game they could possibly play that, as seems always to be the case with these regulatory behemoths, innocent, essential activities are damned along with those regulators mean to sanction. A far more simple regulatory framework backed by considerably more meaningful enforcement would, we think, have been a far more effective way to limit risk, instead of actually increasing it as this proposal well could do.