Volcker Revision’s ‘Toxic’ Loopholes

Volcker Revision’s ‘Toxic’ Loopholes

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

The Fed, SEC, CFTC, OCC, and FDIC are rounding out public comments on their proposed revision to the Dodd-Frank Volcker Rule. Unfortunately, the proposal includes some loopholes hidden in the details that will allow toxic assets to reflate at banks.

The Fed, SEC, CFTC, OCC, and FDIC (collectively, the “Agencies”) are rounding out public comments on their proposed revision to the Dodd-Frank Volcker Rule. The table below highlights some loopholes hidden in the details.

The Agencies’ proposal is an attempt to retrofit banks’ flawed risk management frameworks to the Volcker revision, because such a “risk approach” has proven to be ineffective during the last financial crisis. The proposal will reverse years of effort by the Troubled Asset Relief Program to “separate out the bad bank” and allow toxic assets to reenter the banking system, benefiting merchants of “junk” whom have little or no skin in the game.

According to the St. Louis Fed, “U.S. commercial banks’ holding of treasury and other U.S. agency securities doubled to $2.4 trillion compared to nine years ago,” which fills a vital money gap if the U.S. faces a massive sell-off of treasuries from foreign creditors (see this). Volcker’s favorable policy has made the U.S. government debt less dependent on foreign countries, such as China.

Tragically, the Agencies’ top officials overlooked the Rule synchronization with President Trump’s “America First” principle. Consequently, the Agencies’ proposal would inadvertently push banks to abandon prudent investment in U.S. Treasury and other U.S. agencies’ securities. As a result, it will cause an “irrational exuberance” if banks recklessly pursue higher yields in risky and illiquid products, which is unsustainable. The timing could not be more disastrous amid the largest budget deficit in the U.S. history and the flattening (possible inversion) of the yield curve!

To address a 2008-like crisis, the Agencies should holistic review the outdated deposit insurance mechanism because it is unfit for the 21st century challenges (flash crashes, too-big-to-fail, and financial engineeringabuses in particular). Unfortunately the Fed is proposing to relax the capital rule in parallel with the Volcker revision. Hence, there won’t be adequate capital to address the shortcomings of deposit insurance (moral hazardin particular).

The Volcker Rule not only fills this policy gap, it also addresses the too-big-to-fail issues if implemented properly. We advocate for using innovative RiskTech and BPO to:

• Gauge “reasonableness” in securities inventory each day via an empirical RENTD calculator;
• Distinguish permissible versus prohibited activities, and prevent bypassing of controls via automated surveillance.
• Monitor the banking entity’s investments in, and transactions with, any covered funds.

The current and proposed metrics are not effective to deal with rapidly evolving issues proliferated by hidden problems and silos. If trade activities can consistently be scrutinized per our suggestions, then the Agencies may publicize the percentage of suspicious trades being “red-flagged” to enhance the transparency of the Rule’s implementation. This would essentially eliminate all metric requirements, except the Agencies may ask for, or commission, a “comprehensive profit and loss attribution study” when symptoms of control weakness are identified by the surveillance system.

Besides, we see an opportunity to streamline the Rule’s covered fund provision by rewritten it to become the 21st Century Glass-Steagall Act (i.e., prohibiting banks from participating in hedge funds, private equity funds, and like businesses). To ensure shifted risks won’t come back to haunt banks, one should consider the use of behavioral science to ensure “exit only, no re-entry” – like “letting go” of bad habits or toxic assets.

Finally, the Volcker Rule’s preventive approach is better than salvaging a troubled bank through other regulatory measures. This is because demonstrating compliance is helpful to restore a healthy hierarchy of diversified banks, so that tier-two banks would be ready to step-up in case a failed global systemically important bank is under stress.

Bottom line: It is all about streamlining the right priorities to save costs and foster control improvements to achieve the Rule’s financial stability goals. I’m afraid that’s not the case in the Agencies’ proposal.

Please see the full comments that I have submitted to the Agencies here.

Originally published on the TabbFORUM

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