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I wrote recently about the #OWS Alternative Banking working group preparing public comments on the Volcker Rule. I wanted to give a little bit more context. This is especially important right now because the watering-down period by financial lobbyists is getting intense.

The original Volcker Rule essentially states that banks shouldn’t do proprietary trading at all and they should also not invest in hedge funds or provate equity funds or in any way be liable for losses on such funds.

The idea is that the government and thus the taxpayer is backing (through the FDIC) the money inside banks and those banks shouldn’t use that insurance while at the same time risking the deposits themselves just to make a quick buck. To actually see this law, see Section 619 in the Dodd-Frank act.  The law itself is only 11 pages, and some of that is around timing of implementation, so it’s a quick read.

Again, this 11-page document states what the Volcker Rule is supposed to implement.  It summarizes the high-level thinking behind the rule.  More importantly, the regulators’ mandate is to write a detailed rule that complies with what’s written in the law.  When they ask for comments on the rule, they’re asking how well the rule implements the law.

This sounds pretty clean cut, but of course there are grey areas: for example, the law states that if banks fail to comply with the no-prop trading or hedge fund investing rules, then they’ll get punished by having higher capital requirements as well as fines. But it fails to say how stringent those punishments will be. So one way to technically implement the law is to make the punishment trivial.

The law also claims that the banks should be allowed to trade outside their clients’ direct interests in the name of hedging risks. The granularity of that allowed “hedging” is critical, since if they are hedging at the trade level, that’s very different from hedging at the macro level. The best example I’ve heard of this is that the bank may decide there’s “inflation risk” in their portfolio and start investing in long-term inflation hedges; then this really becomes more of a bet than a hedge but it depends on how you look at it and more importantly how one defines the word hedge.

To a large extent I feel like this could be resolved if we force a short-term horizon on the hedging basis. In other words, it’s a hedge if you can argue that you bought a bunch of 1-month puts so you need to hedge your risk on that one month period. However, a 5-year inflation outlook is clearly more of an opinion. On the other hand, forcing banks, as a group, to think in short horizons has its own dangers.

The law also states that banks are allowed to invest in certain U.S.-backed agencies:

PERMITTED ACTIVITIES… The purchase, sale, acquisition, or disposition of obligations of the United States or any agency thereof, obligations, participations, or other instruments of or issued by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, the Federal Agricultural Mortgage Corporation, or a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), and obligations of any State or of any political subdivision thereof.

There are those who claim that we need to expand the above rule for the sake of national security and to prevent a deep, world-wide depression. Specifically, in this article in the Financial Times, the lobbyists are working hard to allow prop trading in European bonds, a huge market which is currently stipulated to be out of bounds:

They point out that Dodd-Frank exempts US sovereign bonds from the general prop trading ban for fear of disruptions. “What happens if you remove the US banks from Europe and they dump the stuff? Prices could collapse,” said Doug Landy, a regulatory lawyer at Allen & Overy.

There are lots of other permitted activities that don’t necessarily make sense to the historian of how other firms have gotten themselves into trouble: interest rate swaps (which are surely necessary tools for hedging basic bank hedging but it doesn’t seem to be restricted to hedging), spot commodities, foreign currency, and all kinds of loans (including repos). There are plenty of ways for banks to put deposits at risk within these instrument classes.

My conclusion is that, when the Alternative Banking group sends feedback to the regulators, we should separate comments on the implementation of the rule (e.g., what risk measures should be used and in how much detail they should be specified) from comments on the underlying law (e.g., whether this is actually preventing conflicts of interest).

The regulators are supposed to fix problems with the rule, but they can’t fix problems with the law (it takes an act of Congress to fix those).  To the extent that we have problems with what’s in the law itself, it is worth a separate discussion about what the best way is to get those addressed.