The Volcker Rule — which limits banks from risking their own, and more importantly, their depositors’, money on the trading floor — was always supposed to be a regulation that was all about what feels right. Former Federal Reserve chairman Paul Volcker said as much when he advocated for the rule shortly after the financial crisis, equating proprietary trading to pornography with the old line that you know it when you see it.
Nonetheless, in the four years since it has been around, the implementation of the actual Volcker Rule, the one that is more than 70 pages long (though not 800 as critics often claim) has been more about process than principals. Lots of trades that look like proprietary trading have been nonetheless deemed doable under Volcker in part because, by the letter of the law, they’re allowed. The rule has lots of gray areas. I made a list of them a few years ago. But there are more recent examples.
Take the recent controversy around Hovnanian Enterprises Inc.’s credit default swaps. The homebuilder has worked out a deal with Blackstone Group to default on certain bonds in order to trigger a payout on CDS that Blackstone bought. Goldman Sachs Group Inc. and a hedge fund that are on the losing end of that trade have reportedly looked into driving up the price of Hovnanian’s bonds in order to curtail their CDS losses.
Even if Goldman were to buy up the Hovnanian bonds with its own money in a trade that would be to its benefit, the purchases would be allowed under Volcker. The rule only stipulates that banks have to have a client purpose when entering a trade, which Goldman presumably had when it sold CDS protection against a potential Hovnanian default. When it comes to exiting a trade, and limiting losses along the way, banks — even under Volcker — are allowed to do whatever they want. Manipulating the value of the underlying bond related to your client-driven derivative trade with your own money is Volcker compliant.
Another recent Goldman example is the firm’s plan to set up a Bitcoin trading desk, and potentially risk its own money in the cryptocurrency market, which itself is still in a state of regulatory limbo. But again Volcker won’t stop Goldman. There is plenty of evidence that clients want to trade Bitcoin, the key litmus test under Volcker. What’s more, regulators have only brought one enforcement action under the rule, against Deutsche Bank last year, and the cause of the infraction didn’t seem to have much to do with prop trading.
On Tuesday, Bloomberg reported that regulators are set to stretch Volcker’s actual loopholes even wider. The Fed and other regulators are poised to drop a key stipulation of the rule: that any trade that a bank holds for less than 60 days is speculative, and therefore not allowed.
A relaxation of the Volcker Rule was on the Treasury Department’s bank regulator rollback wish list that it put out last year. That regulators are going ahead with it will inflame critics who say the Trump administration is stripping away the protections put in place after the financial crisis, and setting us up for another one. The rewrite, though, doesn’t really reverse the rule’s restriction on proprietary trading. Banks still aren’t allowed to make short-term trades that are in fact prop trades. It just gives regulators more leeway to decide what is prop trading and what isn’t, which again is what Volcker himself advocated for in the first place.
The surprising thing is that despite all the loopholes, Volcker actually appears to be working. It has significantly limited the type of activity it was meant to curtail. Banks have been ramping up their trading risk a bit lately, but it is still way down from what it was before Dodd-Frank. Most banks largely eliminated their prop-trading divisions a few years ago, and there’s no indication they are coming back, even under the Trump administration’s lighter touch. That could be in part because investors want banks to be less risky, but it’s hard not to give Volcker some credit as well.
There is reason to be concerned about the Trump administration’s efforts to soften banking oversight, particularly those that are motivated by the misguided belief that somehow overly restrictive regulations are holding back banks from lending, or at least from making sensible loans. Capital rules should remain stringent and left in place. Save the stress tests. But don’t shed too many tears over the proposed change in the Volcker Rule. Forcing regulators to use their own judgment as to what is a prop trade may make the right regulators more active in policing it. For those who don’t really want to police the rule, or are looking for ways around it, the loopholes were there already.
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