Banking regulation.

Wait, wait! Don’t stop reading just yet! This is important to you! At least, it is if you are the kind of person who keeps your money in a bank (mattress ‘investors’ can move on; you’re a lost cause anyway). Because last Wednesday afternoon, Washington time, five key American regulatory agencies finally signed off on the wording of the 'Volcker Rule.' Paul Volcker (pictured), former chairman of the US Federal Reserve, for whom the rule is named, has described its intent in the following plain terms:

The basic public policy set out...is clear: the continuing explicit and implicit support by the Federal government of commercial banking organizations can be justified only to the extent those institutions provide essential financial services.

OK, perhaps not so clear for anyone who doesn’t keep up to date with the drama of US financial regulation. To translate: as we saw in the global financial crisis, there is a good chance that any major American bank which approaches bankruptcy will be eligible for a bailout from the US government.

This is not because the government particularly likes bailing out banks, but because if a bank does lots of business with other banks, then its failure could lead to market contagion: if one bank fails, banks become very afraid of lending to other banks, people sell all their shares and withdraw their money (presumably to hide it under their mattresses) and, voila, we end up with another recession/depression.

Moreover, if it is a bank that accepts regular deposits (like salary payments), then the risk of people losing all of their savings is politically, economically, and politically (did I mention politically?), too horrible to consider. In principle, the US Federal Deposit Insurance Commission (FDIC) insures most deposit accounts up to a value of $250,000, but the FDIC is not really equipped to deal with mass banking-system failures, and the sight of FDIC officials at a major bank’s headquarters would have about as calming an effect on Wall Street as a breakout of Ebola.

A common cause of bank failure is poor management, like when traders are encouraged to take massive gambles on incredibly risky investments for the sake of their bank and not their clients (see 'global financial crisis'). Hence, the intent of the Volcker rule is that, given the US government has ‘explicitly or implicitly’ (and grudgingly) told bankers that it will bail them out in order to protect the savings of depositors, bankers probably ought to be more careful with depositors’ savings and shouldn’t really be going around investing them in incredibly risky products in a way that doesn’t benefit clients (but does often benefit their own bonuses).

Transactions of the latter variety are what is known as ‘proprietary trading’ – using ‘excess deposits’ from customers to bolster profit for the firm, not the client. Although some banks swear by ‘prop trading’, critics like to note that between 2006-2010, the six largest American banks actually lost more money than they made on this line.

This is not to say that people should not be allowed to invest or work at places that deal in very risky and speculative products. But there are already perfectly good companies that provide higher risk/higher return opportunities (hedge funds, equity funds etc), and in Paul Volcker’s view, if you want to get into that sort of thing, then you shouldn’t expect taxpayers to bail you out if it all blows up in your face.

This all sounds fairly reasonable, but working out precisely what counts as ‘non-essential’ banking activity has been a nightmare. The provision to establish the Volcker Rule came out of an 11-page section within the mammoth 848-page 2010 ‘Dodd-Frank Wall Street Reform and Consumer Protection Act.’ Those 11 pages then formed the basis of a largely unintelligible 298-page proposal collectively written by the five regulatory agencies tasked with finalising the wording of the rule.

Bankers, in particular, did not much like the proposal, and mobilised a campaign against the Rule. Over 18,000 submissions were sent to regulators, mostly from disgruntled financial lobbyists, each of which had to be painstakingly considered. A major point of disagreement was whether the rule would prevent deposit-taking banks from engaging in in-house ‘market making’ and targeted ‘hedging.’ The former involves the buying and selling of a particular security (ie. an asset-backed security like a home loan), so as to create a market in that security, while the latter involves buying up securities that will mitigate the loss of a particular investment decision that a bank client (or the bank itself) has taken (a bit like insurance).

JP Morgan’s Jamie Dimon, one of the few Wall Street CEOs to make it through 2008-2012 largely untarnished, led the charge, and at one point accused Paul Volcker of not understanding capital markets and being therefore unworthy of leading the reform. In short, the message from bankers to Washington was ‘your rule will make it harder for us to make loans or investments on behalf of clients’ and ‘you have no idea what you are doing’.

For a while, bankers seemed to have the upper hand, and the rule languished until April 2012. But then events unfolded which suggested JPMorgan wasn’t as smart as it had claimed. The ‘whale fail’ of a JPMorgan trader in London cost the firm $6 billion due to a poor ‘portfolio hedge’ (and earned them an additional US$1 billion fine).

Freshly armed and replete with a series of ‘helpful’ reminders from Volcker to ‘get moving’, President Obama and his Treasury Secretary Jack Lew set and met the deadline for finalising the rule for late 2013. On Wednesday, the five agencies were finally in a position to agree on the wording of the Rule. This was essential, as any differing interpretations among the agencies would undermine its potency (such as it is). Nine hundred pages of preamble and 70 pages of actual rule later, the Volcker Rule has finally arrived.

Once the Rule is phased in by the end of 2015, bankers will no longer be able to trade funds from their own balance sheets or make bets on highly risky and speculative trades unless they can demonstrate a direct link to a client’s needs. Bankers will also have their remuneration packages de-linked to trades that involve risking the bank’s own money.

Most importantly for banks, market-making and normal hedging are still allowed – on the proviso that traders at deposit-taking institutions keep a specific record of what they are actually hedging against. So if regulators spot an unusually large position on what appears to be a speculative instrument, they can request an explanation, at which point the trader should be able to present a document that explains why the position is actually mitigating another risk. If they can’t, they’re in trouble.

There are also a range of checklists and basic metrics that banks will have to go through when they make certain kinds of trades, and CEOs have to confirm to regulators that they understand how the Rule works.

The question now, of course, is whether it will work. A number of bankers say it won’t, and some are already looking into suing the government into a repeal of the rule. However, that the Rule has attracted such ire from bankers is evidence in itself that it will impact banking behaviour. In fact, it already has: in anticipation of the rule, a number of major banks, including Bank of America, Morgan Stanley, Goldman Sachs and Citigroup have all closed their prop trading desks in the last two years.

As incoming Fed president Janet Yellen has noted, whether the rule will ‘really work as intended’ depends on the vigilance of supervisors. The Volcker rule at least gives regulators additional instruments to intervene if they spot something strange on a bank balance sheet. 

Photo by Flickr user Third Way.