The Volcker Rule, which bans banks from participating in proprietary trading, is still worrying bankers. Financial industry groups are now focusing on an exemption from the rule that allows banks to make certain investments as a part of a legitimate liquidity management program. Regulators will have to distinguish between liquidity trading and proprietary trading. Unfortunately, liquidity trading and proprietary trading are not such discrete activities, making regulators’ jobs difficult, if not impossible.
Banks and industry groups argue that the exemption is so narrow that legitimate liquidity trades could be mistakenly labeled proprietary trades by regulators. In any case, bankers know that the narrower the exemption is, the more trading activity they will have to defend to regulators down the line. According to Berkeley Law Assistant Professor, Stavros Gadinis, “The more flexibility [banks] manage at this stage, the less negotiation they will have to do at a later stage, so this is where it’s at stake, where they can nip it in the bud.” Bankers have to be able to hedge to protect themselves, and the exemption is an attempt to allow that activity while prohibiting the kinds of risky trades that destabilize the market.
Regulators take the opposite view, arguing that the exemption is too broad, and that banks will easily disguise proprietary trading activities as liquidity trading. They worry that the exemption will function as a loophole and allow for risky whale-like trades. But the Volcker Rule, Gadinis said, “would not have stopped the [London] Whale trades. The question of what is a hedge is subject to interpretation. There are things that are definitely hedges, but there are things where it could be, but it’s doubtful.”
Earlier this month, House Financial Services Committee Chairman Spencer Bachus reached out to banking groups seeking suggestions for an alternative to the Volcker Rule. He also criticized the Rule, arguing that it will not stabilize the markets, but rather the reduced liquidity will make it more difficult for businesses to raise capital, reducing job growth and having a “devastating” effect on the economy. According to Gadinis, “The problem is the Rule takes part of the market away. There is less money to go around, so less liquidity. That is the major effect of the rule.”
In their letters to Representative Bachus, banking groups stressed the negative effects low liquidity will have on the overall economy. The American Bankers Association would like to see the Financial Services Commttee warn agencies of the harm to credit availability and liquidity that they see as an inevitable result of the Rule. In its letter to Representative Bachus, the American Bankers Association argues that the kinds of trading banned by the Rule did not cause the financial crisis of 2008, and that inadequately managed risks in a bank’s proprietary trading ought to be handled by supervisory programs that do not impair well-managed bank trading and investment activities. The Securities Industry and Financial Markets Association (SIFMA) suggests as an alternative to the Volcker Rule that Congress rely on “already proposed capital requirements that are under consideration or being implemented as a result of Basel III, rather than activity restrictions.”
Gadinis sees the Rule as working against the realities of markets: “Will it create stability? Efforts to cut the financial system in pieces do not work well because money has this way of flowing around so it’s very hard to contain it with regulatory barriers. My preferred strategy would be to embrace it and see what you can do with it.”
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