Last Thursday President Obama announced the following proposals to restrict both the scope and size of U.S. banks in what he dubbed "the Volcker Rule," after former Fed chairman Paul Volcker:
-- Prohibit any firm that owns a bank from owning, investing in, or sponsoring a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers.
-- Limit consolidation in the financial sector by placing broader limits on the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.
At this early stage, it is difficult to fully assess the credit implications of these proposals for banks. The prohibitions could lead to reduced risk-taking, but they also place U.S. banks at a competitive disadvantage versus nonbanks and foreign banks in attracting capital and employees. Additionally, the proposals could lead banks, in their search to replace lost profits, to expand into other activities that ultimately prove even riskier. Whether the ultimate outcome is positive for bondholders depends upon whether the bank’s risk profile is reduced.
There clearly are more questions than answers. Below are the most pertinent for us.
How is proprietary trading defined?
This question has bedeviled analysts for years. In the strictest sense, any positions initiated independently by a bank might be considered proprietary trading, but that would make it difficult for banks to act as market-makers. To maintain orderly markets, a market maker usually has to hold positions.
Banks also frequently take hedge positions to limit their risk of loss on client-driven exposures. Those hedges do not serve the customer directly – indeed, they intentionally put the bank in a position counter to the client’s. However, without such hedging, banks would have far less capacity to serve customers without exceeding risk limits.
We regard long-term principal investing as a business where most of the benefit goes to employees and shareholders, not bondholders, yet requires bondholders to share a disproportionate amount of the risk. On the other hand, customer-flow trading in liquid instruments that takes advantage of a firm’s distribution franchise with issuers and investors can be an attractive earnings stream for a bank that brings diversification benefits to bondholders – provided the bank has the requisite risk management expertise.
Practically speaking, it may be very challenging to draw a bright line between these two types of activities and limit proprietary trading without damaging market-making franchises.
What happens to nonbanks and firms that de-bank?
This question strikes at the heart of the government’s stated objective. If the objective is to reduce systemic risk and eliminate “too big to fail,” it’s unclear how forcing proprietary trading and principal investing activities into less regulated, or unregulated firms addresses this.
Neither AIG nor the large U.S. investment banks were considered banks or bank holding companies prior to the financial crisis, and yet their difficulties contributed significantly to the crisis, and their interconnectedness with many banks around the world fueled contagion and panic that ultimately could only be addressed with massive government intervention.
Ironically, in many cases their difficulties were not related to proprietary trading, but rather to customer-driven business that was held on (or off-) balance sheet rather than being re-sold into the markets.
Does size really matter?
The limit on liabilities appears an attempt to eliminate “too big to fail.” But does size matter? We believe that “too important to fail” is a more accurate description of this problem.
History shows that the failure of certain financial institutions, by virtue of their deep involvement in the financial system (as opposed to just their size), can pose a tremendous threat to the viability of a large number of other financial market participants. When faced with such threats, governmental authorities frequently chose to bail out these institutions rather than risk the damage to the real economy that might ensue from their failure.
Limiting a firm’s size does not necessarily reduce its importance to the financial markets or the real economy. Other initiatives already underway more directly address this issue, such as the effort to move OTC derivatives clearing to a central counterparty, or the proposed resolution authority that could allow authorities to lift the systemically important functions out of a failing firm. As noted previously, these other initiatives, if successful, could lead us to reduce our systemic support assumptions, potentially resulting in lower bank ratings. But on its own, a size limit would probably not reduce the likelihood of systemic support.
Otherwise, the credit implications of size constraints are not clear. Without the ability to grow assets, banks will feel pressure to find other means to grow their earnings to satisfy shareholders, or else settle for a lower stock price multiple and a more utility-like existence.
David Fanger is a senior vice president at Moody’s Investors Service Inc. This originally appeared in the Jan. 25 issue of Moody’s Weekly Credit Outlook. It is reprinted here with permission.