If you managed to be late to the Volcker Rule party, you can learn a great deal of what you’d need to know via the revealing contrast between two reasonably detailed accounts, one at Huffington Post by Shahien Nasiripour, the other by Matt Levine at Bloomberg. If you didn’t know better, you’d wonder if they were talking about the same rule. But in fact the disparity makes perfect sense: bank stalwart Levine is chipper about the outcome, while Nasiripour stresses how many of the provisions recommended by regulators themselves (!) never made it into the final version.
But let’s step back a bit. The Volcker Rule was an afterthought to regulatory reform, not that the authorities were as serious about that as they should have been in the first place. Remember the genesis: This was a sketchy idea put forth by the White House right after it lost its filibuster-proof Senate majority due to the election of Scott Brown in Massachusetts and it thus felt pressured to burnish its leftie credentials. It was surprising that Volcker allowed his name to be attached to it. But then again, Volcker never demonstrated much enthusiasm for it. I’m told on good authority that he was asked repeatedly to put forth a serious proposal (clearly, the use of his name allowed him to take advantage of the situation) and he demurred every time. And we were never keen about it: the prop trading/customer trading was a spurious distinction, and treating commercial banks as the only backstopped entities after the rescues of then non-banks Goldman and Morgan Stanley as well as AIG was also dubious. That’s not to say the high concept could not have been massaged into something to reduce subsidized speculation, but it was obvious there was not the will to do that.
Now with that low expectation, the progress of the Volcker Rule has had some positive effects. In a “I guess a half a loaf is better than none” outcome, banks had some modest limits put on the size of their in-house hedge and private equity funds. And they all felt pressured to, and did, shut down their formal proprietary trading desks. And it also boosted the reputation of the wonky Occupy the SEC, which got a full 285 citations in the final rule. OSEC was fast out of the box with an initial take, which was a grade of C-:
The regulators are to be commended for certain features of the Final Rule. For instance, OSEC is heartened that the Final Rule includes a CEO certification requirement, in recognition of the inordinate influence that bank executives have in setting the company tone on regulatory compliance. Even so, OSEC remains deeply concerned about numerous provisions. For instance:
The Final Rule inappropriately defines the scope of “covered funds.” Section 619 permitted regulators to limit bank investment into private equity funds, hedge funds, and “any other such similar funds.”
1. The Agencies did not adequately use their authority to include “similar funds” into the scope of the prohibition. This omission paves the way for bank holding companies to evade the Volcker Rule by shifting their proprietary trading activities away from hedge funds into other, non-covered funds. For instance, recent reports suggest that Goldman Sachs intends to avoid the Volcker restrictions by focusing some of its speculative activities in Business Development Companies, which are not only exempt from Volcker compliance, but are also eligible for relaxed oversight and compliance responsibilities under the JOBS Act.
2. Recent reports had suggested that the Final Rule unambiguously closed the loophole for portfolio hedging, in response to the political fallout from J.P. Morgan’s London Whale fiasco. However, the actual language of the Final Rule is not as clear-cut in rejecting the use of macro-level hedging strategies. For instance, the Rule allows hedging to occur on an aggregated basis and across multiple trading desks, without adequate safeguards for particularized identification of risk.
3. The Final Rule exempts repurchase agreements (“repos”) from the Volcker Rule’s ambit, despite the pernicious role that such agreements played in the credit crisis of 2008.
But even if a regulation is well-crafted, what matters is whether it is enforced. Sarbanes Oxley had tough provisions on internal controls that made the CEO and CFO criminally liable for serious violations via certification requirements. As we’ve argued repeatedly they would have made for straightforward cases (at least civil, and they could have been flipped to criminal if the evidence was strong enough) against bank executives for their conduct in the runup to the crisis. Charles Ferguson wrote an entire book, Predator Nation, setting forth other legal theories and supporting evidence for prosecution.
Nasiripour describes how the monitoring side, as in compliance, has the foxes running the henhouse:
The rule promises unprecedented surveillance of big banks’ trading operations, mostly through documentation requirements that force banks to justify trades and strategies and to keep running tallies of whether their activities conform to the rule.
But the establishment of parameters that ultimately will determine whether banks are complying with the rule was left to the banks themselves. The rule also relies on banks to tell regulators whether their trading practices, as they define them, comply with its provisions. Regulators largely will be responsible for double-checking the banks’ work.
“The rule is so conceptual it’s all about the implementation,” said Marcus Stanley, policy director for Americans for Financial Reform, a group that represents more than 250 organizations. “The regulators didn’t draw really bright lines for hedging or market-making. This thing is one giant loophole if it’s badly implemented.”…
Underscoring concerns that federal regulators largely outsourced the task of differentiating between proprietary trading and permitted activities, Sarah Bloom Raskin, the Federal Reserve governor President Barack Obama has nominated to be deputy treasury secretary, said that examiners from the agencies charged with enforcing the rule “will be leaned on heavily.”
“The proposed final rule has taken the approach of not setting explicit limits, but permitting regulated entities to set those limits through their compliance plans, and then monitoring those compliance plans,” Raskin said. “This emphasis on compliance within firm-chosen limits, rather than absolute thresholds, means that the role of supervisors and examiners and in particular the role of supervisor and examiner judgement and discretion become critical.”
Needless to say, front line examiners didn’t comport themselves well in the runup to the crisis. Tom Curry, the recently-installed Comptroller of the Currency, is trying to reform and revitalize the OCC’s deeply captured bank supervisors. While the FDIC is generally credited with having the toughest and most independent bank examiners, they’ve never been involved in capital markets operations, so it is hard to see how they could play a strong role here. So why should we expect markedly different conduct now?
And the enforcement language gives even more cause for pause. The penalties basically amount to telling the banks to cut it out and then having the various regulators invoke their existing power if they see the need (see section starting on p. 855):
The proposed rule implemented section 13(e)(2) in two parts. First, § __.21(a) of the proposal required any banking entity that engages in an activity or makes an investment in violation of section 13 of the BHC Act or the proposed rule, or in a manner that functions as an evasion of the requirements of section 13 of the BHC Act or the proposed rule, including through an abuse of any activity or investment permitted under subparts B or C, or otherwise violates the restrictions and requirements of section 13 of the BHC Act or the proposed rule, to terminate the activity and, as relevant, dispose of the investment.2793 Second, § __.21(b) of the proposal provided that if, after due notice and an opportunity for hearing, the respective Agency finds reasonable cause to believe that any banking entity has engaged in an activity or made an investment described in paragraph (a), the Agency may, by order, direct the entity to restrict, limit, or terminate the activity and, as relevant, dispose of the investment.2794
Several commenters urged the Agencies to strengthen the authorities provided for under § __.21,2795 with some commenters expressing concern that the proposed rule does not establish sufficient enforcement mechanisms and penalties for violations of the rule’s requirements.2796 Some commenters suggested the Agencies add language in § __.21 authorizing the imposition of automatic and significant financial penalties – as significant as the potential gains from illegal proprietary trading – on traders, supervisors, executives, and firms for violating section 13 of the BHC Act and the final rule.2797 These commenters suggested the Agencies incorporate reference to the Board’s authority under section 8 of the BHC Act into the rule,2798 and others encouraged the Agencies to rely on their inherent authority to impose automatic penalties and fines.2799 A few commenters stated that traders, management, and banking entities should be held responsible for violations under certain circumstances.2800 Finally, another commenter recommended that officers and directors of a banking entity be removed from office, be prohibited from being affiliated with a banking entity, and be subject to salary clawbacks for violations of section 13 of the BHC Act and the final rule.2801
The Agencies note that the authorities provided for in § __.21 are not exclusive. The Agencies have a number of enforcement tools at their disposal to carry out their obligations to ensure compliance with section 13 of the BHC Act and the final rule, and need not reference them expressly in § __.21 in order to exercise them.
Now it is fair to point out that only Congress could increase the various agencies’ enforcement authority. But the blather above looks almost certain to translate into a replication of the weak approach bank supervisors use now, of finger-wagging about things they don’t like, which might lead to consent orders if the banks don’t shape up. And even in the SEC arena, where monetary penalties are more common, the New York Times found recidivist behavior was common:
A New York Times analysis of enforcement actions during the last 15 years found at least 51 cases in which 19 Wall Street firms had broken antifraud laws they had agreed never to breach.
One finally has to wonder how five regulators are going to work together to enforce a vague rule. Some of the commentors asked for clarification of duties but they were blown off. It’s easy to see how pretending everyone is responsible can assure that no one really is, which is a useful posture to take if blame ever needs to be shed. It would be useful for a Congressman to ask exactly what the regulators will do differently in the case of an analogue to a MF Global or London Whale set of risks and executive evasiveness.
So while some bankers may be grousing about the outcome, the ones who haven’t hopelessly drunk the industry Kool-Aid will probably recognize that the Volcker Rule has a high optics to substance ratio, which has proven to work better for the incumbents than it serves them to admit.