It was with frustration, but not surprise, that I set out Monday night, having read Paul Volcker’s comment letter, to summarize for my clients the arguments in favor of his eponymous rule, jointly proposed by the regulatory agencies last October.
The "letter" proper – about two pages of text – is a curious amalgam of platitudes and enthusiastic recommendations of the obvious. Just two representative excerpts: "As the rules become effective, periodic review by the relevant supervisor with the Boards and top management will certainly be appropriate, as a key part of the usual examinations process or otherwise"; "to the extent that firms continue to engage in complex activities at the demands of customers, regulators may need complex tools to monitor them."
After this blessedly brief equivalent of reminding the surgeon to wash his hands before operating, the former chairman of the Federal Reserve Board refers us to the four-and-a-half page annex to his comment letter entitled "Commentary on the Restrictions on Proprietary Trading by Insured Depositary Institutions."
The first page of the Annex is a summary of the primary objections raised to the Volcker Rule. The four objections are:
1) proprietary trading does not put banks at important risk;
2) market liquidity will be imperiled by the rule;
3) the competitive position of the U.S. banks will be adversely affected; and
4) the rule is too complicated and costly.
The remaining three and a half pages do not substantially refute any of these objections.
Volcker answers the objections about the rule’s complexity and cost of compliance with a dry retort, "markets are complex and the cost is worth it," even though Volcker himself expressed objection last November to the rule, because it was too long and complicated.
Volcker spends the most time telling us that proprietary trading entails substantial risks. He then tells us: "To be sure, there were many factors other than proprietary trading contributing to the breakdown of financial markets." What he does not tell us, because he cannot, is the name of a single bank that went under and required taxpayer support because of proprietary trading gone bad.
It is never the activities that all recognize as risky that break the bank. Always it is those activities that consensus tells us are low risk – say, underwriting highly rated mortgage backed securities – that sink the ship when consensus proves false comfort.
Instead of data or evidence, Volcker tells us proprietary trading creates conflicts of interests, traders get paid too much more than other bank employees and proprietary trading is "not an essential commercial bank service that justifies taxpayer support." What bank service would justify this support?
Are we to believe, then, that everything not prohibited by Mr. Volcker’s rules is an "essential" bank service? Loans to slot machine operators at harness racing tracks? Underwriting of bonds at shell holding companies to pay dividends to corporate moguls? Loans to unregulated hedge funds to lever up and engage in the exact same proprietary trading prohibited by the rule? Which regulator would Volcker have us trust to fairly and efficiently make this determination? Unanswered questions all.
As to effect on liquidity in the trading markets, Volcker tells us the restrictions of the rule are not at all likely to have an effect on liquidity "inconsistent with the public interest." And to close the loop on his circular and conclusory non-argument, he further tells us that the market participants "should stand on their own feet in the market place, not protected by access to bank capital." In other words, there will be no loss of liquidity other than the liquidity you deserve to lose.
With respect to the bank competitiveness issue, Volcker tells the banks that while they may lose trading profits, they’ll be rid of the greedy traders and given how their culture will improve, who wouldn’t make that trade? Free of the conflicts of interest, the banks will now be able to focus "exclusively on their customer’s needs," no longer "preoccupied with purely proprietary interests." While touching, this sentiment will not replace the capital and talent that has been walking out of the banks’ doors for nearly a year now to the less regulated "shadow" financial market, particularly hedge funds.
"Hedge funds have been the significant beneficiaries of the Volcker Rule," Tom Hill, CEO of Blackstone Group’s $34 billion hedge fund business, reportedly said last March. "The brain drain from the banks has accelerated dramatically."
Who will bail out hedge funds if their proprietary trading bankrupts them? As Long Term Capital Management taught us, the banks – which are still free to lend to hedge funds without limit under the rule.
Richard Farley is a partner in the corporate practice of the law firm Paul Hastings.