Volcker rule and bankers' dilemma

The banking industry, particularly in the US and Europe, has been facing enormous challenges in the aftermath of global economic meltdown which inflicted deep damage to the global economy and financial markets.

Mandatory stipulations from the regulators to improve the capital cushions to withstand future shocks, deleveraging, difficulties in selling distressed assets, toxic assets, haircuts, growing global competition, threatening systemic issues in the light of sovereign debt crisis in the Eurozone, poor economic growth and job losses are some of the issues being faced by the industry after the crisis.

Inescapably, all these challenges exert enormous pressure on earnings and profitability.

In 2011, banks and fin-ancial institutions announced more than 230,000 job cuts mostly in these regions, according to Bloomberg News. Citigroup and Bank of America have announced job cuts to be implemented in the near future.

Averting systemic crisis

Yet another challenge currently faced by the sector is complying with the proposed requirements as stipulated in the Volcker Rule. Paul Volcker is an American economist and former Federal Reserve Chairman appointed by President Barack Obama on matters pertaining to economic recovery. The Volcker rule, which is a part of the 2010 Dodd-Frank Act, prohibits federally insured US banks and depository institutions from making speculative bets and engaging in proprietary trading of debt and equity securities, commodities, derivatives and other financial instruments. In other words, the Volcker rule limits bank investments in private equity and hedge funds as they risk investors' funds in speculative activities.

Paul Volcker, who addressed the fourth Global Financial markets Forum, 2012 held recently in Abu Dhabi, observed that short term trading mentality undermined the commercial banking functions and dragged them to excessive risk taking.

Inflated asset values

His argument is that although this behaviour generates good profits and bonuses in good times, it drags the institutions into heavy losses and possibly to systemic crisis in bad times. This is quite understandable as the demise of LTCM (Long Term Capital Management) and the bankruptcy of Lehman Brothers, have demonstrated that banks and financial institutions have the potential to threaten and pull down a system. Availability of enormous liquidity in the markets inflates asset values leading to asset bubbles. So, this potential threat should be removed from the markets, he argues.

However, people opposing the proposed rule argue that proprietary trading did not cause the crisis. They argue that this rule, if enforced, would discriminate sovereign debt that is not US debt and would hinder flow of capital and competitiveness for non-US banks and financial institutions. These impediments would raise investment cost and increase risks as market for their debt would be limited and could hamper liquidity.

The writer is head of finance and banking programme at the British University in Dubai.