A major post-financial crisis rule meant to curb excessive risk-taking by banks faces major changes in the months ahead.
Legislators and federal regulators from both parties favor revising the Volcker Rule to lessen the regulatory burdens on banks and free up lending. But Wall Street critics fear that even modest new accommodations for banks will set a precedent that allows big banks to return to big speculative bets, subsidized by taxpayers.
The Volcker Rule, named for former Federal Reserve Chairman Paul Volcker, prohibits banks from engaging in proprietary trading — that is, trading for their own profits the way that hedge funds or day traders do. It was a centerpiece of the 2010 Dodd-Frank financial reform law, implemented on the logic that banks should not be speculating with deposits that are insured by the federal government. Otherwise, taxpayers effectively would be subsidizing banks’ bets.
The rule was crafted to allow banks to continue making trades meant to serve their customers. But distinguishing between speculative trading and investment banking is tricky, if not impossible. The rule includes a complicated set of exceptions for banks if they’re hedging risks for clients or engaging in “market-making” by facilitating trades for clients who want to buy or sell a particular security. They also are allowed to trade in Treasury securities.
Next week, the House is set to vote to exempt community banks from the rule. The legislation already passed the Senate in a bipartisan vote and is expected to garner similar support in the House before heading to President Trump’s desk.
But the legislation is only the beginning. Financial regulators are working on a rewrite of the rule, which was finalized in 2013.
Regulators at the banking agencies are likely to propose, within a few months, making it easier for banks to engage in short-term trading, according to the Wall Street Journal, particularly by ending the presumption that any position taken for less than 60 days is speculation and therefore banned, rather than a trade done to meet a bank customer’s needs.
The practice of presuming that every short-term trade is pure speculation is “essentially a guilty-until-proven-innocent principle,” said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a firm that provides analysis and consulting to financial firms. It “quashes a significant amount of sensible and safe activity,” she added, because banks have to prove that short-term trades are necessary to provide customers with a service.
The alternative would be for short-term trades to be presumed to be driven by client need, with bank examiners able to step in and stop them if they believe the trades instead are speculative.
The banking industry has long argued that such changes are needed to relieve them of the burden of complying with the rule and to ensure that businesses are able to get the loans they need.
Recently, there has been bipartisan agreement that the costs the Volcker Rule imposes on banks are not worth the benefits of added safety for the financial system.
Former Fed governor Daniel Tarullo, an Obama appointee, said last year on leaving office that the rule was “too complicated” and that he would support simplifying it, including by exempting small banks.
Tarullo, who oversaw bank regulation at the Fed, also suggested that the rule may be hurting market liquidity, meaning that in certain markets bonds might not be easily bought and sold because banks have withdrawn. A shortfall of liquidity could cause a financial crisis, in theory.
The evidence has been mixed on whether the Volcker Rule has dried up liquidity. Last year, a Securities and Exchange Commission report concluded that the rule hasn’t damaged banks’ ability to lend and that markets are functioning well.
For the meantime, it will take bipartisan cooperation for the rule revision to proceed. That’s because Federal Deposit Insurance Chairman Martin Gruenberg, an Obama appointee, has the final say at one of the five agencies responsible for the rule, at least until Trump’s replacement is installed.
Meanwhile, Wall Street critics fear that any rollback in the Volcker Rule would just be the first, as Wall Street banks would seek to regain the revenue streams from their proprietary trading desks.
Dennis Kelleher, head of the Better Markets group that advocates for tighter financial regulations, argued that allowing banks to engage more in speculation places pressure on the entire firm to engage in more risk in search of profits and bonuses.
“Getting the prop trading cowboys out of taxpayer-backed banks has done more to correct the culture and refocus banks on lending to the real economy than almost anything else,” he said.
Trump-appointed regulators have made it clear that they aim to give banks more leeway in executing trades.
In March, Federal Reserve Vice Chairman Randal Quarles called the Volcker Rule “an example of a complex regulation that is not working well.”
And the Trump Treasury Department proposed several changes to the rule in a report issued in June 2017, including getting rid of the presumption that short-term trades are speculative.
Any proposal from the agencies is likely to “raise all of the issues raised in the Treasury report,” said Jerry Comizio, chairman of the banking practice for the law firm Fried Frank.
Revising it will be a major undertaking. Five agencies must come together to agree to the new rules: the Fed, the FDIC, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission, and the SEC.
This article has been updated to correct Dennis Kelleher’s quote.