The Volcker Winter Storm — Bad Rule, Worse Implementation

On a snowy day in Washington, several federal agencies packed some mean regulatory snowballs that will most likely overshoot their supposed destination of Wall Street and crash-land with a thud on the businesses and investors of Main Street. Rather than postpone the planned vote on Tuesday, when the federal government was officially closed, agencies sheltered themselves from public view and pushed through the rules.

According to USA Today, “CFTC spokesman Steven Adamske said his agency will not hold a public meeting, but commissioners will approve the rules in writing.” This lack of transparency on voting on the rule was symptomatic of a series of last-minute changes from the rule the agencies had initially proposed two years ago. The agencies never submitted these changes for public comment, and thus according to a Reuters analysis, may be vulnerable to lawsuits for violation of the Administrative Procedure Act.

Beyond that, nothing good ever comes when the government utilizes an opaque process to force “transparency” on the private sector. For all the supposed “toughness” of the new rule, there is nothing specific that would prevent something like J.P. Morgan’s much-despised “London whale” trade.

In the meantime, the new rules could sharply reduce the stream of initial public offerings that have been propelling the stock-market upsurge. And just as regulatory impediments to smaller IPOs were relaxed modestly with the bipartisan Jumpstart Our Business Startups (JOBS) Act signed by President Obama last year, the Volcker rule will likely erect new barriers to market making by Main Street banks underwriting the offerings of these smaller firms.

Even as written in the Dodd-Frank financial “reform” statute, the Volcker rule was a solution in search of a problem, or in search of a factor that was not even a minor cause of the financial crisis. The provision, often referred to a “Glass-Steagall lite” — after the 1930s law that was repealed by President Clinton in 1999 — maintains Glass-Steagall’s false dichotomy of inherently “risky” trading and inherently “safe” lending.

And it doesn’t ban or restrict trading based on level of risk, but on whether the trading is “proprietary.” Most discouragingly, in the statute and in today’s edict, the Volcker Rule  contains explicit exemptions for trading in risky government-backed securities, such as municipal bonds and foreign sovereign debt.

There is no evidence that proprietary trading — a bank trading for its own portfolio — is more dangerous than executing trades for customers. In the leadup to the financial crisis, banks traded mortgage-backed securities for themselves and for their customers, but at bottom the instruments were dangerous due to the underlying mortgage loans — loans encouraged by governmental entities such as Fannie Mae and Freddie Mac and by mandates such as the Community Reinvestment Act.

Moreover, even the rule’s architect, former Federal Reserve Chairman Paul Volcker, concedes that banks must do some incidental trading for their own portfolios to carry out other functions. This type of trading includes buying shares to “make markets” for companies they take public and to hedge the risk of ordinary loans such as mortgages.

But in practice, it’s very difficult to tell which type of trading is “proprietary.” As former Sen. Ted Kaufman, D-Del., who (wrongly) advocates bringing back Glass-Steagall, wrote in Forbes Tuesday after the rules were released:

Who’s to know what’s a hedge, what’s market making (trading on behalf of clients), and what’s trading for the bank’s own account? The paper trails can be inconclusive. Like angels on pins, there is never going to be an answer.

And IPOs, particularly for smaller companies, are likely to take a hit. In order to underwrite a stock market offering, banks have to engage in “market making.” They “make” a liquid market for the stock by buying shares in the company to generate demand. But the new rule, according to various interpretations (that will be further revised as the new language is examined), puts many new burdens on this traditional practice.

According to The Wall Street Journal, “the rule … will require banks to provide ‘demonstrable analysis of historical customer demand’ for financial assets they buy and sell on behalf of clients.” But how does a bank show “historical customer demand” for a company that has never gone public before?!

This could have the biggest impact on smaller IPOs, in which banks can’t easily measure “historical demand” and would have to likely buy more shares to create more demand than they would for a larger firm. Some banks may look at the compliance costs, and simply not underwrite smaller IPOs, harming innovation by entrepreneurs and wealth-building by ordinary investors.

This could also slow the growth of IPOs underwritten by non-Wall Street banks. In recent years, and since the modest regulatory relief from some Dodd-Frank and Sarbanes-Oxley provisions from the JOBS Act, regional banks such as Atlanta-based SunTrust and Cleveland-based Key Bank, have increased their sponsorship of new companies going public.

And in further showing that the Volcker Rule and its implementation is not focused on preventing risk, the new rules contain explicit and blanket trading exemptions for municipal bonds and foreign-based sovereign debt. And exemptions for banks to buy and sell securities in Fannie and Freddie, the two proximate causes of the crisis, were already in the Dodd-Frank statute.

The Volcker Rule may create the “perfect storm” of lessened innovation in the private sector and more-of-the-same gambling by government.