Examining the Impact of the Volcker Rule Part II

AT TODAY’S HOUSE FINANCIAL SERVICES COMMITTEE HEARING, lawmakers discussed the impact of the Volcker Rule on markets, businesses, investors, and job creation.

Chairman Spencer Bachus (R-Ala.) began the hearing stating that the Volcker Rule may “adversely affect the ability of American businesses to grow by reducing liquidity in capital markets, and raising the cost of capital for corporations.”  He noted that the Volcker Rule is an “oddly considered afterthought which will not make the financial system any safe and thus should be repealed.”

Ranking Member Barney Frank (D-Mass.) stated that the Volcker Rule could help the “too big to fail” problem by reducing the size of banks in a “functional” way. He said that dire predictions of the rules negative impact are unfounded and the rule will not put the U.S. at a competitive disadvantage.

Rep. Shelley Moore Capito (R-W. Va.) noted that some regional banks have raised concerns about their ability to meet liquidity needs under the Volcker Rule, which would hamper the ability of small and mid- size businesses to access capital.

Witness Panel

James Barth of Auburn University stated the Volcker Rule is based on an incorrect premise, will be very difficult to implement, and will have harmful effects on the economy. He said that the financial crisis was not caused by proprietary trading, but rather by poor lending practices and excessive leverage of bank’s balance sheets. He said that regulators will have difficulty differentiating between what is proprietary trading and what is not, adding that restricting beneficial trading would decrease levels of liquidity and may drive banks to engage in riskier behavior in search of returns.

Barth said forced migration of proprietary trading from banks to non-banks will increase risk in the overall financial system. He stressed that excessively leveraged firms are less capable of absorbing losses and they should be required to hold sufficient capital requirements. He concluded that there is “little upside” to the Volcker Rule and there is no evidence that the benefits exceed the costs. He added that the rule will put U.S. banks at a competitive disadvantage.

William Hambrecht of WR Hambrecht + Co. stated that proprietary trading causes “hazardous exposures” and “conflicts of interest.” He said the basic problem of the financial crisis was “unlimited leverage” of banks allowed by the “dealer exemption” from normal margin rules combined with the extremely low cost of capital borrowed from customer bases. He added that it will be a challenge to create a market with true price discovery due to opaque bank balance sheets. He concluded that the Volcker Rule should help restore lending discipline to the market. He added that the final rule should include limitations on leverage and impose additional capital charges on the activities it permits, such as market making.

Dennis Kelleher of Better Markets stated there are plenty of examples of proprietary trading being involved in the financial crisis. He said many of the largest banks are “too big to manage” citing the example of the “London whale” where executives and managers did not know about the risks being taken by traders. Kelleher said that the Volcker Rule is “narrow in application” and “limited in scope.” He stated the rule will prevent the biggest banks from proprietary trading that is “essentially gambling” where “banks get the upside and taxpayers get the downside.” He said that implementation of the rule will not be difficult if the law: 1) focuses on compensation to break the link between proprietary trading and banker bonuses; and 2) is backed up with swift, certain, and significant penalties for traders, supervisors, and executives.

Kelleher concluded that a ban on proprietary trading will not harm consumers and that it is “likely to unleash a renaissance in our financial industry” as transparency, competition, and fairness create new opportunities for market participants.

Jeff Plunkett of the Association of Institutional Investors stated that the current Volcker Rule, as proposed, goes beyond the intent of Congress and will create burdensome compliance costs for banks. He said that uncertainty regarding the boundaries of permissible activities may force bank dealers to stop facilitating transactions for customers. He added that unless changes are made, there will be disruption in the marketplace. Plunkett said the regulators interpretation of the statute regarding banks’ relationships with hedge funds and private equity firms is “over-inclusive” and “significantly and unnecessarily” harms assets managers that are affiliated with banking institutions. He said that Congress should narrow the definition of “hedge fund” and “private equity fund” to exclude all registered investment companies, foreign funds, and non U.S. regulated funds. Plunkett also said that Congress should clarify the definition of “near term” and state that market making activities taken on behalf of customers fall within the market making exemption.

Thomas Quaadman of the U.S. Chamber of Commerce stated that market making is a critical tool that may be negatively impacted by the proposed Volcker Rule. Quaadman said that the proposal’s trade-by-trade analysis will raise the cost of capital formation and will shut some businesses out of the capital markets. He added that the rule will directly impact the ability of corporate treasurers to mitigate risk for their companies, sell commercial paper, and use efficient cash management techniques. He said that along with Basel III, the rules will “impinge on the ability of business to access commercial lines of credit and will make corporations increase their cash reserves.”Quaadman suggested that the proposed Volcker Rule be re-proposed and that more time be allowed to receive and review comments in order to fix the issues.

Paul Stevens of the Investment Company Institute stated that the Volcker Rule contradicts “the plain language that Congress passed” by treating registered investment funds as hedge funds and that such an exclusion should be provided. He added that non-U.S. retail funds also be excluded as they are already regulated abroad. Stevens stated that the proprietary trading restrictions will not achieve their goal and will have “broader adverse effects” on the U.S. and overseas. He said the rule would decrease liquidity for markets that rely on banking entities to act as market makers, such as the fixed income and derivatives markets. He said that electronically traded funds (ETFs) play a critical role in maintaining efficient pricing in the market place and that banking entities should continue in this role.

Question & Answer

Rep. Francisco Canseco (R-Texas) asked, “is there is a practical way to distinguish between proprietary trading and market making” and also if the final regulation would make the financial system safer. Barth replied that it will be very difficult to distinguish trading activity and this may deter banks from engaging in beneficial trading activities. He said he did not think the rule would make the system safer as it was “poor underwriting” that caused the crisis. He said that the equity capital levels must be sufficient to cover losses.

Rep. Nan Hayworth (R-N.Y.) agreed with Barth on the cause of the crisis, and added that the primary problem is “taxpayer money backing unlimited funding.” She asked what the “most elegant” solution would be to prevent excessive leverage. Hambrecht responded that the key is in looking at the functionality of the trades being conducted and separating proprietary trading from market making.

Rep. David Schweikert (R-Ariz.) expressed concern over the effects the rule would have on liquidity in fixed income products, especially municipal debt. He asked if community players will step in and “play into the margins” of the Volcker Rule. Quaadman replied that the Volcker Rule gives disincentives for taking on state municipal debt and said it will be more difficult for municipalities to raise bonds in the capital markets. He suggested that Congress go back and fix this issue because it may affect community infrastructure projects.

Rep. Maxine Waters (D-Calif.) asked if the Volcker Rule would harm the competitiveness of U.S. banks. Kelleher responded that there is a need for international harmonization, but not for “lowering the bar.” Waters followed up asking if implementation should be delayed until harmonization is reached, to which Kelleher said no and that the rules should be put in place to see how they work before fixes are applied as necessary.

Rep. Joe Baca (D-Calif.) asked is there are any practical transactions in trading accounts that are unclear under the rule. Stevens replied that there is ambiguity of proprietary trading restrictions. He noted that in these trading activities, banks are “guilty” of proprietary trading until “proven innocent.” Baca then asked if the proposed hedging exemption is effective. Hambrecht responded that problems become more complex in the derivatives market when looking at the impact on counterparties. He stated that having derivatives that are more transparent, standardized, and exchange based would be helpful.

Rep. Brad Miller (D-N.C.) asked Kelleher if he thought one of the biggest banks could fail with minimal market impacts. Kelleher said “not yet” and stated there was a long way to go under Dodd-Frank, but that the orderly resolution authority in conjunction with other proposals will one day eliminate “too big to fail.”

Rep. Blaine Luetkemeyer (R-Mo.) asked if mutual funds should be excluded from the proposed rule and if the rule differentiates between mutual funds and hedge funds. Stevens answered that mutual funds are subject to restrictions on portfolios and investment strategies as well as governance regimes that hedge funds do not need to abide by. He recommended that both U.S. and non-U.S. mutual funds be outside the covered funds provision of the Volcker Rule.

Rep. Steve Stivers (R-OH) asked if the Volcker rule needs to be looked at in conjunction with Basel III and if these rules make the U.S. less competitive. Quaadman replied that all of the different rulemakings coming from regulators “play off one another” and added that unilateral rules in the U.S. will make U.S. firms less competitive.

Rep. Carolyn Maloney (D-N.Y.) said that many of the largest banks are already following the guidelines put forth under the Volcker Rule. She said some remaining issues were: 1) unclear “rules of the road;” 2) the need for one set of rules among the five regulatory agencies; and 3) the need for regulations to be mindful of exemptions.

Rep. John Carney (D-Del.) asked if the regulators plan to require entities to show the intent of their trades. Kelleher replied that they do not need to look at intent, but rather the economic interest and stated that it was “not a complex problem” and “banks know and track” what they are doing with their funds. Hambrecht stated that the idea that regulators “can’t figure out” the difference between proprietary trading and market making is “untrue” and that the goal of market making is “normally very clear.”

To view a webcast of this hearing please click here.