Thursday, February 23, 2012

The Volcker Rule: Insights into Wall Street's Opacity Protection Team

This blog has written a number of posts on the Volcker Rule (see here, here, here, and here) to provide some insight into how Wall Street's Proprietary Trading Protection Team operates and what this implies for how Wall Street's Opacity Protection Team is trying to prevent the adoption of ultra transparency.

In a NY Times Dealbook article, Jessie Eisinger looks at the current condition of the Volcker Rule and declares it as good as dead.

The Volcker Rule, named after Paul A. Volcker, former chairman of the Federal Reserve, is meant to bar financial institutions that are protected and subsidized by the federal government from trading for their own accounts. That is, it’s pretty simple: Traders shouldn’t speculate for their own personal gain...
Actually, as simple as this statement of the Volcker Rule is, it is more complicated than ultra transparency.  Under ultra transparency, banks disclose all of their current exposure details.

Under the Volcker Rule, there is a question of is a trader speculating or not.  Under ultra transparency, if a bank has an exposure the bank discloses all the information it has on the exposure consistent with protecting individual borrower privacy consistent with HIPAA patient privacy standards and corporate privacy as it relates to projections of future performance.
Yet bank lobbyists with complicit regulators and legislators took a simple concept and bloated it into a 530-page monstrosity of hopeless complexity and vagueness. 
Besides Wall Street, the members of the Protection Team include lobbyists, complicit regulators and legislators.
They couldn’t kill the rule. Instead, they are getting Congress and regulators to render it morbidly obese and bedridden. 
Of course, that is no accident. The biggest banks, which are in business today only because taxpayers bailed them out, want to protect their valuable franchises. 
“Most of the length, complexity and questions are in there because of industry lobbying,” said Dennis Kelleher ... The rule is “the bastard child of the lobbying industry,” he said. “You can’t demand and insist and lobby for all these rules and exemptions and then complain that it’s too long and complex.”
The banks are making sure the rule stays incapacitated.
By redefining the Volcker Rule so that it is now complex, the Protection Team makes it vulnerable to being squashed.

Fortunately, in its expanded form, ultra transparency still fits on one sheet of paper.
By Mr. Kelleher’s count, of the substantive responses, 13 were pro-reform, compared with 300 from the industry.
Based on your humble blogger's personal experience dealing with comments made on the Article 122a of the European Capital Requirements Directive (this article requires commercial and investment banks, broadly defined, to know what they own when buying a structured finance security), this proportion of responses pro versus against reform is typical.

Unfortunately, as the Committee of European Bank Supervisors showed, regulators favor the preponderance of responses even when the responses were created using the same Word document and printed on different letterhead.

The regulators and legislators deserve some sympathy against such an onslaught. But only so much. Responsibility for the gross inadequacy of the Volcker Rule lies with them. They added the loopholes and exceptions. 
Regulators did so out of vanity. They are confident they will be smart enough to navigate all the complexities. 
Regulators have already testified that they wanted to carry out the rule in a nuanced fashion. 
They aspire to distinguish intentional proprietary trading from unintentional cases, a standard that is tantamount to pre-emptive surrender. That will make enforcement all but impossible without a trader stupidly putting something incriminating in an e-mail.
When it comes to ultra transparency, regulators are acting in a similar fashion.

For example, the Federal Reserve believes that putting over 100 of its PhD economists on the bank stress test exercise means it will be smart enough to catch all the ways that the banks can game the stress tests and determine which banks are solvent and which are not.

Hmmm...100 PhD economist versus the thousands of experts, including from the global banking competitors, the market could bring to bear doing stress tests on the data disclosed under ultra transparency.  Which one does common sense says will do a better job (hint:  PhD economists all believe that for markets to be good at pricing they have to be better at analysis than a group of economists)?
Even at this late hour, regulators still have a choice. The final rule is not in place. They could radically simplify it. The law could merely state that prop trading is illegal at banks backed by the government, and not explain what the inevitable exceptions and exemptions would be.... 
Second-best is to introduce some bright-line rules into this monstrosity. Then Volcker would not be hostage to whichever heavily lobbied regulators happen to be on staff at any given moment....
The regulators' choice should be to require banks to provide ultra transparency and comply with the simple description of the Volcker Rule used at the beginning of the article.  Market participants will exert discipline to reduce proprietary trading.
In all their pages of concerns, what is the anti-Volcker crowd most worried about? Nothing convincing. 
Actually, what the anti-Volcker and anti-ultra transparency crowd is most worried about is their paycheck.  It is much harder to make money when you no longer have the benefit of opacity.

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