Easing the Volcker Rule Would Be Good, Abolishing it Would Be Better
This post is the third in a 3-part series on banking regulation and the Volcker Rule. Read the first post here and second post here.
The Volcker Rule vowed to promote safety and soundness in the financial services industry by banning certain kinds of commercial banks trading. It has not lived up to its promise. The rule mistakenly blamed proprietary trading as one of the causes of the financial crisis, while neglecting the beneficial services that it provides. Its shaky definition and arbitrary enforcement has led to a less-liquid and less-stable financial system.
As a result, the Office of the Comptroller of the Currency (OCC) has sought public comment on how best to revise the rule’s definition and improve enforcement. Meanwhile in Congress, the House recently passed the Financial CHOICE Act that would repeal the rule entirely. Although a full repeal of Volcker through the CHOICE Act would be preferable, there are several actions that financial regulators can take to improve the regulation.
How Should We Reform the Volcker Rule?
While the exact changes to the rule that OCC will pursue are unknown, it is highly likely that they will adopt many of the recommendations made by the Department of Treasury in June this year.
According to a study by PricewaterhouseCoopers that examined the series of Treasury recommendations, there are three measures that are both highly likely to have an impact and highly likely to be implemented: simplifying the definition of proprietary trading, making it easier to hedge, and reducing the compliance burden.
Simplifying the Definition of Proprietary Trading
As mentioned in previous posts, one of the Volcker Rule’s greatest shortcomings is its cumbersome definition. The regulation provides little clarity about what is proprietary trading and what are hedging and market making activities. As long as the rule seeks to ban trades on a proprietary basis, this issue will still exist, although regulators could certainly improve the rule’s definition.
The Treasury report recommends that the definition remove the short-term limit, which defines a 60-day window to prop trades, as well as examining the elimination of the Purpose Test, a subjective test that regulators use to determine the purpose of a particular trade. Many have argued that both of these provisions are obscure, as the length of a trade does not infer intent and the Purpose Test relies upon regulators determining the purpose of a trade after the fact. Simplifying the definition to scale back some of the guessing-games that regulators must play would be an improvement to the status quo.
Reducing the Burden when Hedging Business Risks
The Volcker Rule sought to exempt banks from mitigating certain risks through hedging. Part of the reason it failed to do so is because the exemption requires onerous amounts of compliance paperwork to prove that a bank is properly hedging its risk. The compliance costs are simply too high to execute these trades, and many banks have taken on more risk as a result. Streamlining the compliance procedures for hedging business risk is critical to improving bank safety.
Reducing the Burden of Compliance
The Volcker Rule’s compliance costs were originally estimated to cost the industry up to 2.3 million new hours of paperwork and $4.3 billion dollars. Such extraordinary costs are due to extensive reporting requirements that are not tailored to a bank’s particular risk profile, but rather a one-size-fits-all approach. Instead, the Treasury report recommends that “All banks should be given greater ability to tailor their compliance programs to the particular activities engaged in by the banks and the particular risk profile of that activity.” Reducing the compliance burden on banks will allow them to expend less resources on paperwork and more on serving their customers.
PwC further found that exempting both smaller institutions and highly-capitalized institutions would have a major impact on the financial services industry, although these reforms are less likely to be implemented.
Exempting Small Banks
Paul Volcker’s original idea for the law was to ban proprietary trading amongst the largest four to five banks. Instead, the rule ended up covering many more banks than it was intended to. This has imposed unnecessary costs on smaller, community banks that do not engage in speculative trading, and on those firms whose failure would pose no risk to the stability of the financial system.
Regulators should therefore exempt these smaller institutions that do not engage in significant proprietary trading from the rule. There is no justification for burdening small banks with compliance programs that prevent them from effectively mitigating risk.
Creating a Regulatory “Off-Ramp” for Highly-Capitalized Banks
Exempting institutions that pose no threat to the financial system is a common sense measure. So is exempting banks that are sufficiently well-capitalized that their trading activities are well mitigated. A regulatory “off-ramp” that provides flexibility to firms with the ability to absorb the risks of proprietary trading is a step in the right direction.
Congress Should Abolish the Volcker Rule
All these changes proposed by the Treasury Department would be a welcome start to reforming the Volcker Rule. The current rule is overly complex, vague, and burdensome. It has overshot its original aims, bringing little improvement to the state of financial safety and soundness.
Nevertheless, while these reforms would be an improvement on the current state of affairs, it is hard to see how they could address the fundamental issue with the Volcker Rule: enforcing a particular standard of proprietary trading is incredibly hard without impacting other beneficial types of trading.
It took five regulatory agencies over three years to draft a nearly 1,000-page rule to flesh out exactly how regulators could exempt certain types of proprietary trading from others. This approach has clearly failed, but not because of a lack of regulatory talent. It is simply an impossible standard to administer. To enforce the rule, a regulator must either act arbitrarily, guessing what the intent was of a particular trade, or include an over-encompassing interpretation that impacts activities that are widely recognized as critical to the financial system. Even an improved Volcker Rule will continue to limit a bank’s ability to make markets and hedge against appropriate risk, not to mention the fact that proprietary trading is no more risky than other financial transactions.
The current actions to refine the rule are common sense measures that hold wide support. But while they are a positive step forward, there is an even better move. The Financial CHOICE Act, which passed through the House last month, would abolish the Volcker Rule altogether. In order to bring about a stable and efficient financial system, which ensures bank safety while promoting growth, the Senate should go beyond the OCC to pass the CHOICE Act and abolish the Volcker Rule.