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The Volcker strip – making banking less regulated again

US regulators have disclosed the much awaited revision of the Volcker Rule that had been taken on by the Trump administration. Wall Street has undoubtedly received a huge win, but who is likely to bear the losses?

The Volcker Rule was implemented after the financial crash to stop banks from engaging in proprietary trading (buying and selling stocks, bonds, currencies and derivatives for their own profits). The rule aimed to prevent insured lenders incurring losses that would then have to be bailed out by the taxpayer. Although the ruling was well-intentioned, the wording itself proved to be too cumbersome and difficult to execute in practice.

The banking industry inevitably chafed at the changes, arguing that trying to comply with such an ambiguous rule left them unable to carry out legitimate ‘market-making’ activities that would facilitate commercial transactions. They also felt that the regulation was costing them too much time and money; hiring professionals to help them demystify the confusion over what counted as ‘acceptable activities’ was deemed to be too much of an effort. These complaints found an eager listener in the Trump administration, which then instructed officials to try and ease the burden of regulation on the largest financial institutions.

Thus, the groundwork for Volcker 2.0 had been laid. On Tuesday the 20 August, the Fed and other regulatory authorities disclosed their revised version of the ruling. The rule is due to become effective on Jan. 1, 2020, but banks will have one year to comply. The main changes of the regulation are as follows:

  • The largest banks are still prohibited from engaging in proprietary trading, but the definition of banned trading activities has now been clarified.
    • Under the new clarification, banks can now conduct more short-term transactions that facilitate client trades, which they were unable to do previously.  
    • Overall, regulators have expanded the range of activities that banks can participate in to create enough liquidity.
    • The concern from the opposition is that these changes will allow banks to use the excuse of ‘market-making’ to engage in riskier trading.
  • Larger firms no longer need to demonstrate their intent
    • Under the original Volcker Rule, all firms were required to give an explanation of intent for all short-term trades that fell in the scope of the rule.
    • With the rewrite, only smaller banks have to demonstrate their intent for trades.
    • The rationale behind this is that the bigger banks will already have their trades covered by market risk rules that are a part of their capital requirements.
  • Reversed burden of proof?
    • The original rule held the presumption that trades held for less than 60 days were examples of proprietary trading unless the banks proved otherwise.
    • With the rewrite, specific tests will now be used to determine whether the held trades were proprietary in nature.
    • It is now the role of the regulators to prove that a trade fell outside of the scope of recognised activity rather than the role of the bank to prove that a trade was acceptable.

The core principle of the original rule – the protection of taxpayer funds from banks participating in proprietary trading – has become notably blurred under the rewrite. However, there is no doubt that this recent announcement is a huge win for Wall Street firms that have been given a green light to significantly expand their market-making activities. Conversely, opposition to the revised ruling stems from the belief that it has made it easier for banks to increase risk in their transactions. Their biggest concern is that this increased risk is likely to once again be borne by taxpayers in the case that these trades do not fall in the banks’ favour.

The original Volcker Rule might have been difficult to understand, but this did not mean that it should have been effectively neutered. Although there are other mitigants in place – margin, capital rules and BRRD – that should ideally keep the bigger banks in check, the scaling back of the Volcker Rule can only really seen as a decrease in surveillance. Given the relentless complaining by bigger banks, the clarification of proprietary trading might not come as a surprise, but this does not mean that banks have done anything to earn the benefit of the doubt under the revised rule.

Has the banking reform movement lost its steam? This shake-down of the Volcker Rule has been steadily building. In the European Union’s Liikannen report – a list of recommendations centred on having bail-in recommendations and separating banking activities – the proposals have virtually not been mentioned since they were proposed in 2012. The UK appears to be the only one left with a credible distinction between their retail and investment-banking businesses thanks to the Government’s ring fencing reforms, but we are yet to see the impact of this. The US has not had a structural separation of its sectors since the almighty Glass-Steagall Act of 1933, and this was repealed in 1999 following the familiar lament of over-regulation. The Volcker Rule was a watered-down version of the Glass-Steagall Act, focusing instead on restricting banking activities rather than erecting structural divisions. With the revision of the original Volcker, we are left with banking sectors that have been diluted to homeopathic levels.

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