How to simplify the Volcker Rule

In an American Banker editorial, William Isaac and Richard Kovacevich look at how to simplify implementation of the Volcker Rule.

Regular readers know that your humble blogger has already suggested the simplest way to implement the Volcker Rule and eliminate proprietary trading regardless of where the trade occurs and is accounted for on or off the bank balance sheet.

The simplest way to implement the Volcker Rule is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this level of disclosure, there is no hiding proprietary trading from the market or escaping discipline to close the position.

As the authors observe,

Regulators, politicians, bankers, and former Federal Reserve Chairman Paul Volcker himself are all searching for a simple, easy to understand, yet effective way to implement the Volcker Rule that is consistent with a safe and sound banking system....

Only ultra transparency meets all of these criteria.  It is simple.  It is easy to understand.  It is effective.  It is consistent with a safe and sound banking system.

The Volcker Rule, which is part of the Dodd-Frank financial reform law, is intended to impose strict limits on banks engaging in "proprietary trading" – i.e., betting the bank's capital by significant speculative trading in financial instruments.

Ultra transparency virtually eliminates proprietary trading as disclosure of these trading positions invites market participants to trade against the bank.

Congress, as usual, gave general direction to the regulators to figure out how to implement the concept.  

The regulators' proposed rulemaking on the Volcker Rule is a whopping 298 pages of complexity that is not only difficult to understand but nearly impossible to monitor and regulate.  There is a better way....

The better way is to require ultra transparency and simply leave the Volcker Rule as it is; a simple statement that bans proprietary trading.

But like many financial products, especially loans, proprietary trading indeed has risk.  This risk should be carefully and intelligently monitored and regulated. 

The question regulators are trying to answer is this:  Is the risk of holding an inventory of securities to enable customers to readily buy or sell securities through a bank reasonable, or is it so excessive that changes in the market price of that inventory could put the institution in serious jeopardy?

By requiring the banks to provide ultra transparency, the market can see if the banks are holding "inventory" or making "proprietary trades".

Market discipline will not be limited to just the proprietary trades.  It will also extend to the issue of is the bank holding so much inventory that it puts itself at risk.  In this case, market discipline will take the form of a lower stock price and higher cost of borrowed funds as market participants need to be compensated for the "inventory" risk.

It's perfectly legitimate and logical that a financial institution, like any seller of products in any industry, would hold more of a product in inventory if it thinks the price of that product might go up in the near future, and hold less of it if the bank thinks the price might go down.  We would not call this proprietary trading but rather common sense....

It's foolhardy to try to read the minds of traders at financial institutions to determine if the inventory they are keeping is larger than the expected demand....  

The authors make a very important point.  It is hard to tell where holding inventory to satisfy customer demand ends and where proprietary trading begins.

That is why ultra transparency is the only solution that works.  In the case of a proprietary trade, market participants can exert discipline through trading against the bank.  In the case of excessive inventory, market participants can exert discipline through demanding a higher return to compensate them for the risk the bank is taking.

Financial institutions cannot earn more than their cost of capital without taking risks. 

Moreover, they are of no value to their customers or the economy unless they take prudent risks.

A key feature of ultra transparency is that it does not prevent financial institutions from taking risks.  It subjects the financial institutions to market discipline and hence acts as a restraint to only take prudent risks.