Saturday, January 15, 2011

Implementing the 'Volcker Rule'

The Wall Street Journal reports that [emphasis added]
Top U.S. financial regulators charged with issuing recommendations on how to implement the "Volcker rule" appear to be leaning against suggesting precise rules for specific assets or trades, and instead might focus on the amount of risk being carried by a firm or trading desk, according to people briefed on the negotiations.
Included in the sweeping financial-overhaul law passed last summer, the Volcker rule, named for former Federal Reserve Chairman Paul Volcker, seeks to prevent banks from putting capital at risk by prohibiting proprietary trading and banning certain relationships with hedge funds and private-equity funds. It left much of the details on how to do that with regulators.
After months of sometimes tense work, financial regulators reached a tentative deal in recent days on recommendations about how the Volcker rule should be implemented, said one industry official briefed on the situation. The study is expected as early as Tuesday, when the regulators who comprise the administration's Financial Stability Oversight Council meet.
Regulators have kept details of the nearly 80-page draft close, and its content is subject to change until the council votes to approve it.
What is becoming clearer is that the document likely won't propose that regulators look at each and every trade, people briefed on the matter said. Instead, it will discuss reviews of large trades and the amount of risks firms are taking on a broader basis. Regulators would then decide whether trading desks are taking on too much risk. This approach would be seen as a win for the financial industry, and could irk Democrats who pushed the provision into law last year.
This approach most definitely would be a win for the financial industry.

Perhaps more amazingly, it completely disregards the advice offered on October 12, 2009 by Goldman Sach Chief Executive Lloyd Blankfein in a Financial Times editorial.

One lesson from the crisis is the need for more effective systemic regulation. There has been a focus on who should exercise this responsibility. But the most critical question is what the systemic regulator should do, and what responsibilities will make it effective – not who, so much as how?
Regulators need to be able to identify risk concentrations early and prevent them from growing so large as to threaten the system. If systemic problems arise, regulators need to take prompt action to limit their impact and protect the safety of the system.
To do this, the systemic regulator must be able to see all the risks to which an institution is exposed and require that all exposures be clearly recognised. 
... It is not enough even that all exposures be identified. An institution’s assets must also be valued at their fair market value – the price at which willing buyers and sellers transact – not at the (frequently irrelevant) historic value. Some argue that fair value accounting exacerbated the credit crisis. I see it differently. If institutions had been required to recognise their exposures promptly and value them appropriately, they would have been likely to curtail the worst risks. Instead, positions were not monitored, so changes in value were often ignored until losses grew to a point when solvency became an issue.
At Goldman Sachs, we calculate the fair value of our positions every day, because we would not know how to assess or manage risk if market prices were not reflected on our books. This approach provides an essential early warning system that is critical for risk managers and regulators.
Here is the chief executive of Goldman Sachs arguing that the only way to manage risk is by looking at each and every position.  No exceptions.  By definition, this same view of what it takes to identify and manage risk applies to the Volcker Rule.

The proposed implementation of the Volcker Rule is a win for the financial industry because it also violates the FDR Framework.

Rule 1:  Investors should be provided with useful, relevant information in an appropriate, timely manner.

Under the Volcker Rule, regulators should be looking at how to make the asset-level detail for each bank's trading and investment business available to all market participants.  This way, besides regulatory oversight, analysts and competitors could exert market discipline to restrain proprietary trading and the amount of capital at risk in either the trading or investment business.

Using 21st century information technology, making current asset-level information available to all market participants can be easily done at very low cost.

Instead, the regulators appear to violate the transparency rule by keeping these businesses shrouded in 1930s level opacity.

Rule 2:  Governments should not endorse specific investments

By being the only party with access to asset-level information, regulators are explicitly endorsing the safety and soundness of the banks despite their abysmal track record of identifying and mitigating the losses in the trading and investment books of the large banks at the beginning of the credit crisis.

If Goldman cannot manage its risk without looking at all the asset-level data, regulators cannot manage the risks that the Volcker Rule is suppose to minimize simply by looking at a sampling of large trades. 

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