When the president signed the financial reform bill in July, one of the most trumpeted components was the Volcker Rule, most often expressed as restricting banks from making certain kinds of speculative investments on their balance sheets if they are not done on behalf of their customers. This approach came from the belief that it was the uncontrolled and highly leveraged speculation in risky assets that led the banking system to the edge of the precipice. It is based on the assumption that restricting this kind of trading by banks to off-balance-sheet entities will make the insured institutions less prone to failure.
The Volcker Rule, as it was included in Dodd-Frank, already has begun to change the banking landscape. Several banks and large dealers have started restructuring their proprietary trading desks, putting them into hedge-fund-like subsidiaries. Some proprietary trading desks deal in relatively complex products, whose price performance may be volatile and difficult to predict, but many others deal in such plain-vanilla products as U.S. Treasury securities or simple interest rate swaps, the kinds of instruments that banks have been trading for many years.
Whether spinning these desks off will do much good is open to debate.
On the surface, these developments might look like just what the doctor ordered, getting commercial banks out of the trading business and making things much like they were before Glass-Steagall was repealed. However, the long-term implications of this rule change are not at all clear.
Here are some as-yet unknown implications:
• Will these arrangements really shield banks from the risk? One only need look back a couple of years to the well-documented cases of structured investment vehicles to see how thin and transparent the corporate veil can be. SIVs were special purpose entities set up to purchase long-term fixed-income assets and finance them in the money markets.
As could have been predicted, the SIVs' ability to obtain short-term financing disappeared when the quality of their assets declined. Banks, which set up these SIVs expressly to get risky assets off their balance sheets, almost universally collapsed them back onto their balance sheets when the strategy went south. Another spinoff example was the Bear Stearns hedge funds that purchased assets from Bear in good times, only to sell them back to Bear before they were closed down. Simply shifting something off one's balance sheet as a risk management strategy has proven time and again to be a fallacy instead of a solution.
• Will these arrangements simply increase the trading risk in the market? Banks with large balance sheets may be in the position to absorb trading losses without collapsing themselves.
If their trading positions are concentrated in off-balance-sheet entities, most of which will be pretty thinly capitalized, will drastic reversals in the markets simply create bigger ripples?
Thinly capitalized traders rely on high leverage, and it is a market axiom that high leverage among investors means high market volatility.
Beyond that, who will supply the leverage to the off-balance-sheet entities, and under what terms? Nothing perpetuates a financial panic like a string of highly leveraged market players defaulting on their obligations.
• If banks can continue to carry derivative positions on their books, both in securities and instruments, because those positions are created in the process of serving customers, then will the Volcker Rule have dealt with a small problem while leaving a much bigger one untouched?
For example, the weak mortgage assets that sank many of the banks and investment firms were there because these businesses originated them and sold some (but obviously not all) of them to their customers. One would hardly expect these organizations to voluntarily move this business to hedge-fund-like subsidiaries. In addition, almost all swap positions that banks take are in response to customer inquiries, or to lay off the risk incurred to service those inquiries, and wouldn't be affected. So the remedy prescribed by the Volcker Rule may fix the headache and leave the tumor.
• What role will national borders play in this new high-risk trading? No other country has passed a version of FinReg or the Volcker Rule. In particular, with the exception of the "banker bonus tax," London (the center of much proprietary trading) seems not to have changed much of its financial regulation structure. So, if the next meltdown is concentrated in the off-balance-sheet hedge-fund-like bank subsidiaries, which regulator will step in to stop the panic? Which central bank will provide the credit facility when money market funds break the buck? Whose laws will dictate the inevitable bankruptcies?
The fact that we don't know the answers to these questions isn't just troubling, it's extraordinarily dangerous.
As the Volcker Rule is now part of the law, how will banks deal with it? We already are seeing the first wave of migrations off bank balance sheets into hedge fund subsidiaries as well as the first hints of a migration of traders from banks to bank subsidiaries.
Whether these trends will persist, and what their real effect will be on banks and the markets, remains to be seen, yet the most important law pertaining to the Volcker Rule may be the law of unintended consequences.
