In this day and age, when two legislators of starkly opposed ideologies are both concerned with a particular issue around the same time, take note. Recently, this has been the case with consequences of the new Volcker Rule.
One of the goals of the Dodd-Frank Act was to reduce the likelihood that a bank would get caught in a fire-sale environment holding speculative assets. The focus of the Volcker Rule was to prevent banks from engaging in speculative trading, whether by taking proprietary trades (betting with their own money) or by owning interests in risky endeavors doing the same thing (covered funds). Figuring out how to write such a regulation without affecting banks ability to make markets for customers was extraordinarily difficult. It took the regulators over three and a half years, during which most of the effort was focused on proprietary trading.
Whether they succeeded or not remains to be seen. The Bipartisan Policy Centers Capital Markets Task Force recommended the regulators take a principles-based approach, as opposed to the rules-based approach they ultimately adopted. What is coming to light is that regulators may have created a scenario where the rule they are proposing could inadvertently create an unnecessary fire sale.
A fire sale can occur when the only people selling something are those who are forced to. With a flood of sellers without leverage, buyers can demand ever-lower prices. In normal economics, once prices fall too low, sellers will stop selling and hold onto their assets, and prices will return to normal. However, if someone is forced to sell no matter what the price then a fire sale can spiral. This also damages those who dont sell, by reducing the value of their assets far below market.
The proposed Volcker Rule contains a restriction on banks owning certain types of assets, known as collateralized loan obligations. Volcker prohibits banks from owning equity or equity-like interests in CLOs. If this prohibition were only forward looking, no fire sale would result; banks could simply refrain from buying and the market would adjust. However, the prohibition as currently written prohibits banks from owning certain CLOs, including legacy CLOs. It requires banks to divest themselves of these assets within a specific timeframe.
It so happens that many CLOs written over the last several years contain these features and were purchased by banks. To some degree, CLOs were the new form of asset-backed securities and the failures and fire sales of certain asset-based securities were an integral part of the crisis. Thus, regulators have every reason to look very carefully at these instruments. In fact, prohibiting future ownership of unstable CLOs is probably a good thing. The question remains what to do with those that have already been purchased.
Forcing a select group of banks to sell these assets over a short time is not the optimal solution. Such action would create an environment of institutions forced to sell and of buyers who can purchase CLOs at extraordinarily cheap prices. This would create unnecessary losses at banks and produce windfall profits for those who can demand to buy them at below market rates.
Nevertheless, regulators should not ignore the issue and only look prospectively. If current CLOs are problematic, regulators should use their standard tools of risk-based capital charges and stress tests to force banks to hold sufficient capital commensurate with the risks of these assets. The more problematic the CLOs are, the higher the capital charges and the worse the performance on the stress test should be. Banks can then decide whether holding these assets are worth the cost and move accordingly.
Such a course of action would depress prices and would create an incentive to sell, but it would not create a fire sale environment in the markets. Banks could retain the assets at a cost for a period of time. Ultimately this problem would work itself out and these assets would run off the books.
A group of House Democrats including, Rep. Maxine Waters, D-Calif., ranking member of the House Financial Services Committee, recently wrote to regulators to "urge the agencies to find a solution that, to the extent possible, avoids the need for unduly disruptive, marketwide renegotiations of existing CLOs." Their letter was very specific to an issue regarding managerial structure (who has ownership control), which affects a large number of these CLOs. Rep. Scott Garrett, R-N.J., also raised concerns about the treatment of CLOs under Volcker at a hearing earlier this month. The broader point is correct: a strong Volcker Rule should aim to prevent fire sales, not cause them.
Aaron Klein is director of the Bipartisan Policy Center's Financial Regulatory Reform Initiative. He served as a deputy assistant secretary for economic policy at the Treasury Department from 2009-2012.