Introducing the Volcker Rule

It’s arrived! Tuesday the Fed, FDIC, OCC, CFTC and SEC unveiled the Volcker Rule, which began as a 3-page letter and now weighs in as a 71-page law with an over 800-page preamble. Like most financial measures, the rule aims to create a “safer” financial system, this time by banning banks’ “proprietary trading”—banks’ trading for profit in their own accounts. However, we’d note the rule seems mostly feckless. It swings and misses at defanging financial crises a la 2008’s, and it also doesn’t materially negatively alter the landscape for Financials today. The rule’s finalization and seemingly unsurprising provisions should alleviate uncertainty—a modest positive for bank stocks and stocks generally. That, at least, is our initial impression of the rule’s highlights—there might be some unintended consequences buried in the almost 1,000 pages of the rule we haven’t scrutinized yet. As we find ‘em, we’ll let you know.

But what the Volcker Rule isn’t is a surprise. Since 2008, reform has been as close to inevitable as anything gets. There is a long history in the US (and globally, we’d add) of shifting regulation in a backlash against crises’ perceived causes. Think Sarbanes-Oxley, Glass-Steagall, the Federal Reserve Act of 1913 and many more. Dodd-Frank, or its ilk, was going to happen—the only question was how it would look. As that broader reform took shape, the Volcker Rule emerged as a major provision. But in the three years since Dodd-Frank became law, the Volcker Rule has shape-shifted rather radically. Volcker himself, in fact, says he has few clues about what’s in his namesake rule.

Initially, it sought to ban all proprietary trading, based on the belief banks shouldn’t take undue risk with depositors’ money. Which is philosophically sensible enough when you consider depositors don’t intend to take principal risk—if they did, it’s likely they would seek something higher yielding than a bank account. Yet a full trading ban would have hit several other services banks provide, principally underwriting and market-making (trading securities and keeping inventory to maintain liquidity for clients)—and banks’ ability to hedge. Regulators figured this out quickly, and they’ve spent three years figuring out how to give banks flexibility without creating vast loopholes.

In the time since, various iterations have been rumored to require segregation of any trading, to cap investment in foreign sovereign debt, eliminate banks’ investment in hedge funds and require CEO guarantees of compliance with the rule—with violations carrying SarbOx-like civil and criminal liability. This past Tuesday, we finally gained clarity about all those issues. So what’s the rule say?

Notably, the Volcker Rule permits market-making—but with caveats. By July 2015, banks must demonstrate holdings are reasonable based on near-term client demand. Holdings in excess would be deemed impermissible proprietary trading. The definition of “reasonable demand” is therefore critical. The rule uses a backward-looking measure—“demonstrable analysis of historical customer demand”—a complication considering banks (like most businesses) build inventory in anticipation of demand. The two-year window before implementation will provide banks an opportunity to gain clarity on this issue, but it’s worth noting.

In addition, banks may trade foreign sovereign debt. This was a widely watched aspect of the morphing rule abroad. The global financial system is so closely bound together that capping trading in sovereign debt could pose big negative consequences as foreign regulators could have imposed restrictions on US Treasury trading. Unlikely as it may have been, a trade tiff that involves banks and sovereign bonds is a poor idea. And we wouldn’t want a Volcker Rule that violates the Golden Rule!

The rule does permit hedging, though banks must hedge against a specific risk (not blanket risks, as the failed “London Whale” trades attempted to do). CEOs will be required to attest in writing their firm has procedures to be compliant with the Volcker Rule—a greatly watered-down version of that rumored executive guarantee. Finally, the Volcker Rule limits banks’ ability to invest their capital in hedge funds and similar vehicles.

Importantly, banks have already taken steps to address the changes stipulated by the Volcker Rule—further mitigating negative consequences. Bank of America CEO Brian Moynihan said proprietary trading is already a thing of the past, and the firm has been selling its stake in hedge and private equity funds for years. Goldman Sachs has also dialed back hedge fund exposure from $15.4 billion in 2010 to $14.9 billion—both negligible figures relative to Goldman’s roughly $900 billion in assets.ⁱOther banks similarly report taking steps to mitigate the potential impact.

In the end, our initial take remains: The Volcker Rule was a solution seeking a problem and does little to de-risk the financial system. But it also is showing up pretty much as expected, mitigating negative fallout. In the end, this incrementally benefits banks and markets as it puts an end to speculation the rule might morph into something more heinous.