The passage of the Volcker Rule will probably be one of the most important determinants of financial firms performance in the upcoming year, mainly due to the combination of the pervasiveness and ambiguity of the almost 900 page document.
I have had several discussions with CFTC Commissioner Bart Chilton who–despite the seemingly sanguine look on my face–I have the utmost respect for. I consider the Commissioner to be a diligent, intelligent regulator with only the best of intentions and a true understanding of the markets along with the realistic capabilities and the limits of financial firms. The Commissioner was a key person at the CFTC in regards to the completion of the Volcker rules, he struck a great balance between pragmatism and doing the utmost to protect investors. Bart has worked tirelessly and the financial community will miss his presence and intellect when President Obama replaces him next year.I hope that the next appointee will be as involved and as open as Commissioner Chilton has been.
After 3 years of development, the passage of the rules by the regulatory quintuplet of the Federal Reserve Board, Federal Deposit Corporation (FDIC), Securities Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC) was finally unveiled along with key tenets of the proposed reform law passed by Congress in response to the financial crisis. Ironically, although proprietary trading wasn’t the reason for the financial crisis, it was a particular focus of prohibited banks activities. Along those lines neither hedge funds or private equity firms caused any of the financial malaise but both were also excluded from bank participation by Congress. Look for the latter two sectors to perform incredibly well in 2014 as the banks are sidelined from participation and the rules are not applied to either respective industry.
The rules do however affect any financial concern with federally insured deposits, this now includes the investment banks as they were forced to become BHC’s (Bank Holding Corporations) by the Federal Reserve Bank during the financial crisis–whether they wanted to or not–and forced to take capital. Financial experts and academics agree that while reform advocates praised the initiative, it is effectively fixing something that wasn’t broken and it doesn’t address the roots of the financial crisis.
I initially discussed the timing additional year delay to July 2015 along with the coordination issues and implications of the proposed rules in Volcker Rules! Most notably, the former Federal Reserve Bank Chairman made it a point to distance himself from the final product that bears his name and similarly outlined some of the points that I voiced in this commentary when I met with him at the International Monetary Fund meetings in Washington, D.C.
A particularly gray area for regulators and lawmakers alike was the concept of hedging. When it comes to liquidity providing and the eventuality of making profits due to the risk taking there isn’t a clear demarcation between client activities and trading profits or losses. After over almost 20 years of capital markets participation as a trader, investment banker and asset manager–I can’t clearly discern the difference and I have not met any professional trader who can. It initially would seem that the litmus test is whether the firm made a profit. The comparisons of market-making and permissible hedging in juxtaposition to proprietary trading—is incredibly hard to distinguish between on an institutional trading desks. Banks will still be allowed to participate in the proprietary trading of US government, state and municipal bonds along with other US government backed financing firms such as Fannie Mae and Freddie Mac–entities which, strangely enough were in the center of the last crisis. The Volcker rules will also allow the banks to invest in foreign bonds.
The financial community applauded that market making activities were left intact, this is incredibly important to financial firms because the total annual revenue of these practices exceeds over $40 billion USD—that translates into $10B a year in pre tax profits according to Standard and Poor’s. A number of top firms like Goldman Sachs, JP Morgan Citibank and Bank of America previously generated significant portions of their revenue from trading. Those activities and revenues will have to be generated elsewhere if they are to remain competitive. The general trading environment has dropped 30% since 2007 and those that are left have seen a corresponding 35% reduction in pay, we can expect that trend to continue and far less capacity in the financial industry in the future taking away from GDP.
With over 892 pages, who are the other groups applauding the rules? Lawyers, Lobbyists and Consultants! The ensuing confusion should create lots of billable hours as the documents are the perfect trifecta of vague, voluminous and ambiguous. The extensive interpretations should add to the economy’s GDP as the lawyers look for loopholes, consultants advise both sides and lobbyists push for legal change of the existing rules.
A key point in the rules is that CEO’s will have to attest to compliance programs making them fully accountable as the CEO assures responsibility. The banks are required to create and monitor compliance programs that the CEO now has to certify. This means that they can be prosecuted for malfeasance as the CEO is ultimately responsible and subject to litigation.This tenet was seen as a key victory by finance critics.
Ultimately these measures will raise costs for US banks causing them to be less competitive than foreign banks while reducing their profitability. Expect foreign banks and the unregulated “shadow banking” sector to capitalize on their conspicuous absence.