Mullin: Regulators are strangling banks with badly focused rules.
WE’RE ABOUT TO discover the true cost of JP Morgan’s London Whale losses as the US regulatory witching hour for the final version of the Volcker Rule draws near. The US$6.2bn in losses were relatively minor for a bank the size of JPM, and their greater damage was always going to lie in undermining the banking lobby’s pushback against regulatory fervour around proprietary trading. Indeed, the Whale proved a perfectly timed and mouth-watering opportunity to conservative and revenge-seeking lawmakers to get their pound of flesh.
Three of the five US bodies that will push out full and final versions of the rule – the Federal Reserve, the Federal Deposit Insurance Corporation and the Commodity Futures Trading Commission – are scheduled to go public in the coming week. The Securities and Exchange Commission and the Office of the Comptroller of the Currency will round out the set in short order. Regulators have been playing their cards close to their chests on the final version of the rule, but the signs are that it will be more stringent than the draft and the Whale has been mentioned in multiple dispatches as a clear example of why. US Treasury Secretary Jack Lew has been very clear to the top US banks that he’s pushing for tough action.
While the basic intent of the rule is clear – limiting banks’ ability to jeopardise the financial system with highly leveraged speculative bets using their own capital – I’ve always been slightly bemused by the out-sized degree of importance this element of Dodd-Frank has garnered. After all, it wasn’t prop trading that caused the global financial crisis but regulators, using the ”never let the truth get in the way of a good story” adage that have whipped up hysteria around it to fever pitch.
Some of the arguments in favour of curtailing prop trading, such as it doesn’t have any economic value, are utterly ridiculous and irrelevant. You can certainly argue about potential conflicts of interest vis-a-vis client activity but that’s a reason for forcing transparency, clear conflict resolution and other good governance metrics, not banning it. And by the way, since when did private equity – which does create economic value by investing in and improving businesses – ever blow up the system?
As I’ve mentioned in the past, the regulatory initiatives in situ or which are being layered in over the next few years are clearly intended to force a very hard steer towards no risk-taking as a basic method of risk control. Regulators are strangling risk in all of its forms in order to get to their utility banking and best-efforts agency broking operating models. In the case of the former they reckon this is the safest form of banking even though, as history has shown us countless times, it’s nothing of the sort if it’s conducted poorly.
The London Whale proved a perfect opportunity to revenge-seeking lawmakers to get their pound of flesh
THERE IS NO real clarity around how Volcker will deal with genuine and reasonable concerns expressed around market-making and hedging. If higher capital requirements have already seriously wounded market liquidity by pushing up the cost of holding inventory, the Volcker Rule’s likely inability at the margin to distinguish between prop trading and market-making will be another nail in the coffin of investors’ ability to get in and out of positions quickly, certainly in size.
Market-making is a fundamentally critical plank of a functioning financial system. Among other things, liquidity spawns price formation in the capital markets. This, too, has economic value. I agree with SIFMA’s view that Volcker fails to address the root causes of the financial crisis. Its primary concern with the October 2011 draft is the potential negative impact on market liquidity.
“As proposed, the rule’s narrowly-crafted exemption for permitted market-making activity exceeds Congressional intent and overly prescriptive and burdensome compliance requirements could well depress the market making functions of banks and their affiliated broker-dealers as well as the asset management alternative fund business. Restrictions on the ability of firms to make markets will reduce market liquidity, discourage investment, limit credit availability and increase the cost of capital for companies. This will have the cumulative effect of stifling economic growth and job creation,” the lobby group has said.
And on the issue of hedging, I can see practical difficulties in exactly matching, say, parts of a dollar/yen currency book to Japanese stock index positions to the satisfaction of box-ticking regulators.
IN TRUTH, EVER since the rule was crafted, banks that did have significant prop trading desks have exited; to all intents and purposes prop trading no longer exists as an activity by banks. It’s morphed fully into the shadow banking sector. Goldman Sachs shuttered its legendary equity arb Principal Strategies group a couple of years ago, forcing a group of traders led by Bob Howard to decamp to KKR to set up the Equity Strategies team. Around the same time, Morgan Stanley cut loose its highly successful Process Driven Trading desk into PDT Partners, an independent hedge fund run by its founder Peter Muller and backed by Blackstone, among others.
I fully understand the impetus behind creating a safer financial system in order to protect taxpayers from costly bail-outs. But like so much of the current crop of regulations, the Volcker Rule could have an opposite effect to the one intended by killing liquidity and making markets more volatile, more dangerous to navigate and more expensive for borrowers and trading counterparties. It’s another fine step in the wrong direction.
(For Anthony Peters’ take on Volcker: click here)