On June 6, the Federal Reserve proposed a change to the Volcker rule, a part of the post financial crisis Dodd-Frank Act that prohibits proprietary trading by insured banks and their affiliates. Advocates of the Volcker rule say proprietary trading is too risky for banks, so there were some immediate fears that any change to the rule might lead to a dangerous loosening of controls on the financial system.
That’s not what this change is intended to do. Rather than relaxing the prohibition on proprietary trading, the proposed revision of the Volcker rule is an attempt to enforce the prohibition “without undue burden” by replacing “overly complex and inefficient” compliance requirements with a “more streamlined set of requirements”, as the Fed chairman, Jerome Powell, describes it.
The Federal Reserve and the other agencies that enforce the Volcker rule are the ones who drafted the revision.
The existing enforcement approach is simply too burdensome: It requires banks to show that each trade they undertake isn’t speculative but is initiated to serve as a hedge or to make a market in a particular security. There is no clear criterion to use when making that argument, so there is a significant risk of getting it wrong.
To avoid that risk, banks avoid some market making. Aggravating that problem, the rule presumes that any security held for more than 60 days in the trading book is a proprietary trade. To avoid having to defend a 61-day holding, banks may liquidate securities held for market-making purposes. This is a particular problem for certain bonds, where transactions are infrequent.
The Volcker reforms rationalise compliance in two major ways. First, US banks would be grouped into three tiers. The top tier — currently 18 banks, doing 95 per cent of trading — would be subject to the strictest requirements. The second tier would face lower burdens, and the third tier, with very small trading books, would enjoy a presumption of compliance, unless it came to light that they were involved in proprietary trading.
Second, compliance procedures would shift from legalistic box-checking toward meaningful economic criteria. Kevin Tran, a supervisory financial analyst at the Fed, said banks will be “required to establish a compliance programme commensurate with the size, scope and complexity” of their business. Their programmes must include “written policies and procedures, internal controls, a management review framework, independent testing and audit, training and record-keeping requirements.”
Banks would also have to establish approved risk guidelines to gauge whether they are engaging in proprietary trading. For example, if a bank never suffered a large gain or loss on a set of trades, that would support the presumption that it was engaged in market making, and consequently, less detailed monitoring of individual trades would be needed.
Banks are not the only ones who will gain from the rule change. Anyone who might want to buy or sell debt securities or foreign exchange will benefit. Global banks are uniquely positioned to make markets in debts and foreign exchange, given their global reach and their knowledge of clients’ holdings and preferences, which allows efficient matching of buyers and sellers.
The fall in inventories of securities held by banks in recent years, which the Volcker rule may have contributed to, makes it harder to maintain price stability. The reforms are well-crafted, but they don’t do enough to promote efficiency in financial markets.
Regulations other than the Volcker rule, such as limits on simple leverage and liquidity requirements, are probably more binding constraints on banks’ market-making inventories in debt markets. Those regulations act as a disincentive to holding low-risk debt instruments in trading books. A carve-out from those rules would encourage banks to hold low-risk debt inventories and would improve debt market liquidity.
Furthermore, encouraging market making isn’t enough. Proprietary trading serves an important purpose in the market. Done prudently, with appropriate capital requirements to absorb losses, it can improve the liquidity and efficiency of financial markets.
As its critics have long pointed out, the Volcker rule has effectively eliminated bank involvement in low-risk trades, such as arbitrage transactions in debt and foreign exchange markets. There used to be predictable quantitative relationships between interest rates and exchange rates in global financial markets.
Those relationships no longer hold, evidence that there is insufficient trading to keep prices efficiently connected to one another. Reduced bank involvement in these markets, because of the Volcker rule, is likely a major source of the problem.
These disconnected prices complicate the execution of monetary policy and risk management by firms.
To be sure, there are risks to proprietary trading. But there are alternatives to prohibiting it, as the Volcker rule does. Those risks could be dealt with by capping the amount of proprietary trading and requiring banks to maintain generous loss-absorbing equity buffers.
It is important to mitigate the risks of proprietary trading, but just as important to understand its value.
— New York Times News Service
