The Volcker Rule: Proposed vs. Revised – 5 Predictions for the Watered-Down Regulation

The Volcker Rule: Proposed vs. Revised – 5 Predictions for the Watered-Down Regulation

By Kelvin To, Data Boiler Technologies, LLC
Originally published on the TabbFORUM

With all of the likely revisions, the Volcker Rule has ceased to exist except in name. Here are 5 predictions on the risks resulting from a watered-down rule.

The likely Volcker Rule revisions have been so well articulated that they have “almost felt like hope” when it comes to advancing risk practices. Supervisory agencies and the industry seem to be in harmony on many of the proposed changes – debunking their elusive plot now is like being a party pooper; but the rule has ceased to exist except in name. So let’s predict what will happen.

Prediction 1: Most Promising Hype

Imagine an upbeat speech by President Trump describing how holistic, innovative, and cost-effective the new Volcker Rule revision will be, followed by Treasury Secretary Mnuchin or Acting OCC Comptroller Noreika elaborating on the benefits of ERM, CRB, risk data aggregation, advanced risk models, central monitoring, etc.

By adding fluff and buzzwords borrowed from a number of supervisory objectives and risk concepts, risk management becomes the most promising Volcker Rule hype to distract you from scrutinizing whether bank genuinely trade on behalf of customers, or engage in proprietary bets to speculate in the markets. There are important differences between the two activities. Bank customers could suffer from inherent conflicts of interest (see this empirical research by Steven and Steven). It’ll be imprudent not to curb abusive and exploitation behaviors of banks.

Although a huge proprietary trading loss may not necessarily trigger an emergency bailout of a bank using taxpayer money, a billion dollar trading loss could trigger systemic failure, like the downfall of Barings and other crises (see this). In the case of JPMorgan Chase 2012 trading loss, it was more than $6 billion. The purpose of the Volcker Rule is aimed exactly at addressing flaws in this JPMC case (i.e., “mischaracterized high risk trading as hedging, hid massive losses, disregarded risk, dodged OCC oversight” – see 2013 Senate report for details). Industry experts have predicted an increase of such risk events might be coming. Given that flash crashes could be fueled by banks instead of high-frequency trading firms (see this/FCA findings), brace yourself for market disruptions.

Prediction 2: Reasonably Irresponsible

Following the 2012 JPMC case, there was a Bank of America (BoA) case in which risk limits were set too high and the bank allegedly triggered 15 occasions of mini-crashes in the market between late 2012 to mid-2014. How would that be “reasonable” under the Volcker regime?! Sadly, after the Volcker Rule came into effect in 2015 the Credit Suisse (CS) case emerged in which the CEO was “blindsided” by the bank’s added risk positions. CS incurred more than a billion dollar trading loss in 2016. Despite the fact that RENT-D/inventory was mentioned 581 times in the final rule to emphasize its importance, the industry hasn’t been serious about what’s “reasonable.” In April 2017, Deutsche became the first ever bank to receive a fine, of $19.71 million, for allegedly violating the Volcker Rule. In particular, the Fed’s enforcement order said the bank “did not subject trading desks’ RENT-D methodologies to sufficient review or challenge by internal control groups.”

In my opinion, though, regulators are majoring in the minors to pinpoint the “formality” of how risk appetite is set. They forgot that some of the biggest threats are the result of many small incremental exploitations or hedges and/or commitments – each accumulating into outsized bets or bubbles. These toxic positions can be so tangled up that banks do not want to hold risky assets because of higher capital surcharges. But a fire sale could cause major losses for the bank, or potential crashes, similar to what happened in the BoA case. It’s a dilemma for trading desks to determine optimal strategy and market timing for their protective hedges. The FCA findings have exposed the ugly truth about how quick banks withdrew liquidity at the time of the crash. In short, RENT-D must consider the dynamic of market microstructure and be calculated at least daily.

Prediction 3: Catch Me If You Can

RENT-D is about the right amount of trades at the right time, whereas outsized bets might be syntheticallycreated. The rogue trader in the 2008 Société Générale (SG) case was being slick to cancel fictitious or suspicious trades whenever he was challenged by the control department. He would replace the bet using a different instrument, or a series of combo-trades, to bypass scrutiny. Unauthorized trades were totaling as much as $72 billion.

The matter isn’t so much about risk culture or a bank’s governance control (given SG failed despite Daniel Bouton’s pride in the bank’s internal control strengths). It’s all about agility of risk management practices and timeliness to act upon warning signals. Sadly, policy makers did not take heed of the lesson. They accepted the lobbyists’ proposal to eliminate a transaction-by-transaction approach to trade surveillance, and things aren’t so transparent anymore. That little footnote 711 on 79 FR 5592 has killed the opportunity to address the 21st Century’s biggest financial threat: abusive use of financial engineering techniques.

It’ll be worse if the rebuttable presumption (“guilty until proven otherwise”) clause is repealed. Banks will no longer be required to “demonstrate” compliance. Good luck identifying irregularities and catching rogue alchemists through the use of flawed metric reports (remember: JPMC, which invented the most widely used Value-at-Riskmetric, also failed in 2012).

Prediction 4: Whose Job Depends on It?

Many put the covered fund requirements on a backburner, as they thought banks would have until 2022 to comply under the Federal Reserve’s extension. The reality is that the deadline was intended for a stable run-off of illiquid funds prior to 2014 only. Banks ought to ensure no new investments or transactions with any covered funds since July 21, 2015.

Bloomberg was trying to offer a covered fund identifier (CFID) product that uses CUSIP as its sole searching criteria. Yet the existing definition of covered funds and related exemptions are much broader and comprehensive. Thus, the effectiveness of such a CUSIP matching tool was challenged by the Fed’s FAQ#17 and this SIA briefing note.

Foreign covered funds and other private investment vehicles do not have standardized CUSIPs. The job will be a huge undertaking to manually go through the countless offering documents in order to determine their permissibility. This is indeed a bigger burden on banks than complying with the proprietary trading ban provision. Interestingly, the Fed recently issued a No Action Relief (till July 2018) on certain “qualifying foreign excluded funds.” It is becoming obvious who is going to benefit the most if the covered funds’ definition is drastically narrowed to just Hedge Funds (HFs) and Private Equity Funds (PEFs) with CUSIPs.

Prediction 5: Done Before It Is Cooked  

Instead of separating commercial and investment banking, as did the Glass-Steagall Act in the 1930s, separations have already been made between banks and HFs/PEs. It shifts much of the proprietary trading risk away from the banking system. Many ex-bankers indeed join or start their own HFs/PEs, which surprisingly have a positive effect on the market with more diversified players. Though some bank alumnus at HFs/PEs do receive sponsorship money from their old employers, that implicit control by banks is through an arm’s length.

However, if the 3% limits on bank’s sponsorship of HFs and PEs is lifted or significantly increased, and affiliated transactions are more tolerant than the existing Super 23A/23B requirements, then books might get easier to cook!!

Originally published on the TabbFORUM

This column does not necessarily reflect the views or opinions of FinReg Alert or Tradeweb Markets LLC.