The House debates the Volcker Rule

The Volcker Rule disallows proprietary trading by banks that hold customer accounts and prohibits them from investing in hedge funds and private equity firms.

12th Chairman of the Federal Reserve Paul A. Volcker gives a speech at the Foreign Policy Association's 2016 Financial Services Dinner on the role of the U.S. government at home and abroad. (Video still from YouTube video of the event)

WASHINGTON, April 3, 2017 —The Volcker rule is again the subject of much debate in the House of Representatives. Implemented in 2015 after lengthy debate, the Volcker Rule, among other provisions, disallows proprietary trading by banks that hold customer accounts and also prohibits those banks from investing in hedge funds and private equity firms.

Named after former Federal Reserve Chairman Paul Volcker, the Volcker Rule was passed as part of Dodd/Frank banking overhaul. That legislation was aimed at heading off the possibility of another economic catastrophe similar to the disastrous Great Recession of 2007-2010 depending how it’s calculated.

But those opposing its stringent terms, including large banks as well as many members of the Republican majority are challenging both the basis for and even the necessity of this rule.

“The line between impermissible proprietary trading and permissible market making is virtually impossible to draw,” said Congressman Bill Huizenga (R-Mich). “As a result, banks are getting out of the market-making business for fear of running afoul of the Volcker Rule. This a great detriment to the U.S. capital markets in my opinion.”

Huizenga made that statement at a Capitol Hill hearing of the Capital Markets, Securities, and Investment Subcommittee of the House Financial Services Committee, which he chairs. The subcommittee is currently  examining the Volcker rule.

Several critics at the hearing of the rule also noted the difficulty of determining allowable market making trading and dis-allowed proprietary trading, with Illinois Republican Congressman Randy Hultgren (R-Ill.) claiming it required regulators to read minds.

“If you want to be trading you need a lawyer and psychologist sitting next to you to determine what your intent was (in each trade),” Hultgren said, quoting JP Morgan Chase Chief Executive Officer (CEO) Jamie Dimon. “Or maybe Governor Powell’s quote,” he said, referring to Federal Reserve Governor Jeremy Powell. He quoted Powell as stating “The Volcker rule effectively forces you to look into the heart and mind of every trader on every trade.’”

Jeb Hensarling (R-Texas), chairman of the full Financial Services Committee, has also been a chief critic of the rule, arguing it has created a dangerous lack of liquidity in corporate bonds. Hensarling is not on Huizenga’s sub-committee.

Arguments on the rule fell largely along partisan lines, with Democrats favoring the rule.

“I strongly support the Volcker rule,” said New York Democratic Congresswoman Carolyn Maloney. “Banks should not gamble with their customer’s money.”

Said economist Marc Jarsulic, currently serving as Vice President for Economic Policy at liberal think-tank the  Center for American Progress,

“The connection between the decline in bond inventories and the Volcker Rule is in reality not very strong. As analysts for Goldman Sachs have pointed out, the very large run-up in corporate bond inventories pre-crisis reflects the accumulation of positions in private label mortgage backed securities rather than traditional corporate bonds. They estimate that the declining issuance and collapsing prices of private mortgage backed securities explains the decline in dealer inventories from their peak levels in 2007 through 2012.

“Moreover, while critics of the Volcker Rule have long forecast dire consequences for the corporate bond market – including declining liquidity, and harm to the functioning of the capital markets – these negative effects have not materialized.”

Jarsulic was one of five witnesses and the only one to support the rule.

Arguing against the rule, Thomas Quaadman, Vice President of the US Chamber of Commerce, noted

“The Chamber opposed the Volcker Rule at its inception because of its potential to negatively impact the market-making and underwriting activities needed for businesses to access liquid debt and equity markets.

“In the alternative, the Chamber proposed higher capital standards as a means to promote financial stability if a covered financial institution chose to engage in proprietary trading.

“Market makers play an essential role in financial markets, acting as a source of liquidity that keep markets vibrant and make investing feasible. As market makers, banks must hold inventories of the financial instruments in which they make markets. For example, corporations rely upon the ‘market making’ activities of banks in order to secure affordable funding in the bond market. Without these ‘market making’ activities, banks would be unable to underwrite these bonds. Thus, if banks can no longer hold inventory, it will be much more difficult for businesses to raise the amount of capital needed.”

Democratic Congressman from Connecticut Jim Himes (D-Conn.) asked rhetorically, “Does anyone here (directed to the five witnesses) think that federally insured banks should be making proprietary bets?”

“Every trade under Volcker is presumed to be proprietary,” replied Ronald Kruszewski, CEO of Stifel Corporation, a full-service trading and investment firm, observing, “that’s bad policy.”

“The burden is not on the regulators to explain why insured institutions should take proprietary bets,” Himes fired back. “The burden is on the industry to find constructive ways — if there are constructive ways — to determine legitimate inventories for market making.”

“I cannot stress how important the Volcker Rule is,” added Congressman David Scott (D-Ga.) “I call to your remembrance the situation with the London Whale… The Volcker rule must stay in place.”

The so-called London Whale was a JP Morgan trading desk employee in London, who took a series of increasingly large bets in credit default swaps until it cost the bank $6.2 billion in 2012. Proponents of the rule, including then Secretary of the Treasury Jacob Lew, often referred to these trades in advocating for the Volcker rule.

Though $6.2 billion is a significant sum for almost any entity, JP Morgan Chase currently manages approximately $1.7 trillion. While the controversial London trade caused some embarrassment and short-term fluctuations in JP Morgan’s stock price, it had negligible effect on the overall health of the bank.

Republicans and Democrats each cited studies that backed up their side of the argument. Ironically, each position cited a Federal Reserve study.

Republicans repeatedly referred to a December 2016 study done by Federal Reserve staffers, which found that “Focusing on downgrades as stress events that drive the selling of corporate bonds, we document that the illiquidity of stressed bonds has increased after the Volcker Rule.”

Congresswoman Carolyn Maloney (D-New York) cited data provided by the Federal Reserve, showing that value at risk (VAR) was not affected by the Volcker Rule.

But Ronald Kruszewski replied that he has seen the real-world effect, stating

“With all due respect to all the studies that are going on here, I run a firm that tries to make markets in compliance with the Volcker rule, and I will tell you that our ability to do so has been significantly affected raising the cost of capital.”

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