The banking lobby has recently whipped itself into a frenzy over regulators’ proposed implementation of Section 619 of the Dodd-Frank Act, better known as the Volcker Rule.
The lobby’s primary complaint has been that the Volcker Rule will hamper liquidity in the financial markets. This claim is belied by the recent flourish of activity in the junk bond markets, which led one industry insider to opine: "This rise in volume is a strong indication that brokerage houses were crying wolf about the reduced liquidity that was supposedly resulting from the anticipated implementation of the Volcker Rule."
In fact, if David Viniar, the chief financial officer of Goldman Sachs, is to be believed, the Volcker Rule will actually lead to increased bank profitability.
Moreover, and quite significantly, the Volcker Rule does not impede nonbank actors (e.g., funds, pure investment banks, broker-dealers, etc.) from stepping in to replace any missing liquidity. Such actors will gladly make markets abandoned by government-backstopped banks if doing so would be profitable and efficient. The Volcker Rule simply removes a costly government subsidy from the banking industry, thereby resulting in a more competitive and efficient marketplace for capital.
Furthermore, even if liquidity in financial products were affected, that would only serve the interests of the economy and the American people. The explicit and implicit government subsidies that banks enjoy create inefficient and artificial levels of liquidity from the perspective of free market ideology. While the Volcker Rule will broaden spreads in illiquid products, those wider spreads will more accruately reflect the actual risks inherent in such products. Spreads in illiquid markets are, at present, artificially narrow. Much of the liquidity that exists, especially in the market for esoteric financial products, is actually funded by taxpayers, and to a lesser extent, bank depositors.
Bloomberg News has reported that the U.S. government made available to U.S. and foreign banks between $1 trillion and $16 trillion (depending on calculation methodology) of free money under largely secret loan facilities. It took a lawsuit and a denial of judicial review by the Supreme Court for the Federal Reserve to get those numbers disclosed.
In passing the Volcker Rule, Congress saw fit to stem the tide of free capital that currently flows to banks, in order to reduce the financial burden on taxpayers and depositors. Senator Jeff Merkley of Oregon, a chief architect of the Volcker Rule, has recognized that any negative impacts that the rule may have on banking profit centers are greatly outweighed by the benefits to be enjoyed by the country as a whole from greater financial stability. This is one area where Congress got things right.
Another fallacious argument bandied about by bank lobbyists is that proprietary trading played no role in the recent financial crisis. Congress closely examined the issue in the run up to the passage of the Dodd-Frank Act, and determined after exhaustive deliberation that proprietary trading by large-scale banks was a principal cause of the recent financial crisis. As recognized by numerous commentators and by the Volcker Rule itself, banks can take on proprietary positions through traditional trading activities as well as through ownership interests in funds that serve as conduits for risk-taking. No serious observer would discount the pernicious impact of esoteric securitizations on the global economy in the last few years.
In any case, from a more pragmatic perspective, complaints about the Volcker Rule’s effects on liquidity and the supposedly benign nature of proprietary trading are akin to crying over spilled milk. The Volcker Rule is law, as Congress saw fit to pass it after extensive research and industry input. The regulators do not have the power to undo that fact. The only relevant issue at this point is whether the agencies stay true to Congressional intent in their implementation of Section 619.
Unfortunately, they are failing to do so.
As Occupy the SEC details in our recent comment letter, the agencies’ proposed implementation of the Volcker Rule strays from Congressional intent in several material ways. For example, the proposal includes a blanket exemption for repurchase agreements, even though "structured," or customized, repos can contain elements of proprietary trading and even vanilla repos can be used to fund proprietary positions. The proposal also fails to treat carried interest (the excess profits captured by an investment manager) as an ownership interest in a bank-sponsored fund, despite the fact that carried interest is treated as such for certain bankruptcy and tax purposes.
There are no bright-line rules or automatic metric triggers to meaningfully define the parameters of exempted market making. The proposal fails to define the characteristics of otherwise-permitted activities that would be barred under the statutory limitations for conflicts of interest and high risk.
The carve-out for loan securitizations is poorly defined, such that synthetic securitizations (those backed by derivatives – think of CDO-squareds) may be permitted despite Congressional intent. Similarly, the rule fails to set adequate limits on banks’ seeding of covered investment funds. And an ill-defined hedging exemption has the potential to defang the entire rule.
Occupy the SEC rallied behind the Volcker Rule because of its enormous potential; if strongly enforced, it can protect the interests of the average person living in the United States from risky banking activities that have imperiled the global economy. If the adage "a rising tide lifts all boats" is right, one might expect the banking lobby to support the Volcker Rule, and drop the flawed "liquidity" argument that has dominated the discourse around the rule thus far.
Akshat Tewary is an attorney practicing in New York and New Jersey and a member of Occupy the SEC, a subgroup of the Occupy Wall Street movement.