Getting the Volcker Rule right may be a waste of time

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In a series of op-eds about the Volcker Rule published in American Banker almost four years ago, I argued that the proprietary trading ban’s complexity, abundance of exemptions and the overly generous discretion afforded to banks subject to the rule would likely make implementing it a “fool’s errand.” Four years later, I am even more convinced that as the rule stands now it does not make the banking system any safer.

There are significant shortcomings in the resources allocated to financial regulators for them to adequately monitor and enforce the Volcker Rule, and banks have inadequate systems and risk data aggregation to produce reliable metrics in order to comply.

The five regulatory agencies responsible for enforcing the rule are understaffed and do not have the necessary IT systems to monitor traders. It is unreasonable to expect that regulators offsite or onsite can determine whether a trade is really on behalf of a customer or whether it is for proprietary trading. Because the Volcker Rule applies to banks, it is then bank examiners and offsite bank supervisors who bear the most significant responsibility to determine whether banks are complying.

I have long argued that banks’ Volcker Rule metrics cannot be trusted, because the metrics are very data-intensive and there is a lot of flexibility in how banks can calculate them. For example, you can use multiple models to calculate the Value-at-Risk and stress testing metrics. Moreover, global systemically important banks in their own self-assessments to the Basel Committee on Banking Supervision admit year after year that they still cannot adhere to the Principles for Effective Risk Data Aggregation, commonly known as BCBS 239. This means that they have significant weaknesses in their systems, how they collect risk data, and how they report it to their own risk managers and bank regulators. Under these circumstances, it is not possible to trust that Volcker metrics are correct and that they really tell regulators the level of risk that traders are taking.

It is unfortunate that banks have spent millions of dollars fighting the Volcker Rule. Bank executives could have used this money to improve IT systems and to hire invaluable professionals in the fields of IT and data science. The Volcker metrics require banks to improve significantly their data collection, analysis and reporting.

It is just as disappointing that regulators have yet to require banks to disclose their metrics to the public. As such, how can investors, ratings analysts, legislators and the media know anything about banks’ Volcker Rule compliance and the true extent of banks’ risks in their trading portfolios? I also find it troubling that regulators have proposed changes to the Volcker Rule without the public knowing the results of those metrics and how often bank regulators use them for enforcement. Democratic Sens. Sherrod Brown, Jeff Merkley and Elizabeth Warren are right to ask for more disclosure.

It is also troubling that the proposed rule essentially will allow banks even more discretion to determine the “market making” or “hedging” services that they can provide to clients. As pointed out by the non-partisan Systemic Risk Council, “This echoes the big mistake made by the Basel Committee when it allowed banks’ internal models to determine their capital requirements.”

“Given the incentives banks face, the current proposal risks eroding the core substance of the Volcker Rule,” the council said.

If we really want to make the banking system safer, it may be worth looking beyond the Volcker Rule at policies that might have a greater impact.

I recommend two things that in my view would be far better than the Volcker Rule as it stands now. First, increase the leverage ratio, which is harder to manipulate than capital ratios based on internal models that are not transparent to the public. Securities and derivatives are in the denominator of the leverage ratio, so the more trading banks do, the more they must allocate in common equity to sustain unexpected losses. Second, require banks to better disclose to the market how they measure credit, market and operational risks with a lot more granularity than what is required now.

And if regulators and legislators still want the Volcker Rule, the metrics need to be published so that the market can discipline banks that take on too much risk in their trading portfolios.

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