Volcker fights back as prop-trading ban comes under attack

Former Fed chair tells Risk.net that calls for total overhaul of eponymous rule are misplaced

Paul Volcker
Paul Volcker: sees little need to make substantial changes to the interagency regulation

  • Paul Volcker has mounted a spirited defence of the bank proprietary trading ban that bears his name.
  • His comments follow speeches by the Federal Reserve’s Daniel Tarullo and William Dudley, in which both questioned the complexity and effectiveness of the Volcker rule.
  • Bankers see Volcker relief coming in one of three ways: a revision of the interagency Volcker rule; a softening of the Volcker rule compliance regime by supervisors; or a legislative repeal of the law in Congress.
  • Trading desks suspect regulators are not even analysing the quantitative data metrics they are reporting under the Volcker rule; they compare the experience to reporting into a “black hole”.
  • Despite the mounting pressure, Volcker remains steadfast in his belief that the prop-trading ban has made markets safer by compelling banks to close their prop-trading desks.

“The effort has not been futile,” the voice of Paul Volcker roars out of the speakerphone, energised more by enthusiasm than anger. “The banks have eliminated their proprietary trading desks – they’re gone.”

The former Federal Reserve chairman is responding to recent criticism of the rule that bears his name, not only from well-established foes on Wall Street and in the Republican party, but also from senior Obama era regulatory appointees who have begun to publicly question the utility of the proprietary trading ban.

In a speech delivered on April 4, departing Fed governor Daniel Tarullo surprised many by effectively stating the rule is both too complex and too burdensome to be retained in its current form. 

“Several years of experience have convinced me there is merit in the contention of many firms that, as it has been drafted and implemented, the Volcker rule is too complicated. Achieving compliance under the current approach would consume too many supervisory – as well as bank – resources relative to the implementation and oversight of other prudential standards,” he stated.

In a speech given just three days later, William Dudley, president of the New York Fed, said policymakers “might re-examine the implementation of the Volcker rule” and floated the idea of “giving greater discretion to trading desks that facilitate client business”.

The speeches by Tarullo and Dudley – who have long been among the most hawkish of all bank regulators – have emboldened long-time opponents of the Volcker rule. “I interpreted Tarullo’s comments to be an attempt to give some forward momentum to attempts to alter the regulation,” says a former Fed staffer turned bank lobbyist.  

Those attempts seem to be gathering momentum. Risk.net spoke with 17 regulatory sources – including lawyers and lobbyists for the largest US banks, as well as current and former supervisors – who described a three-pronged effort to repeal or roll back the Volcker rule.

I get stopped on the street now more so than I did when I was chairman of the Federal Reserve by people who say, ‘Thank God for the Volcker rule’
Paul Volcker

“There are different things that can be done to reform the Volcker rule at the statutory level, the rulemaking level and at the enforcement level,” says Gabriel Rosenberg, a partner in the financial institutions group at law firm Davis Polk in New York. “I think there certainly will be attempts to introduce legislation on Volcker and there are also countless elements that could be changed in the Volcker regulations themselves. What those changes should be will probably be up to the vice-chairman for supervision at the Fed and the heads of other Volcker agencies.”

Volcker himself remains defiant and full-throated in his defence of the proprietary trading ban, which he insists has considerable support among the public and even within banks. “I get stopped on the street now more so than I did when I was chairman of the Federal Reserve by people who say, ‘Thank God for the Volcker rule’. Beyond that, I’ve heard from people within banks who have said this has really changed the environment within banks, especially around the trading desks, which were filled with conflicts of interest. The rule has reduced that culture.”

A regulatory re-proposal

Rolling back the Volcker rule will not be easy.

Prior to the US presidential election, bank lobbyists told Risk.net the most feasible route to achieving that goal would be to work with the heads of the regulatory agencies charged with enforcing it to “tweak the calibration” of the existing rules.

Those who see the sheer complexity of the Volcker rule as its glaring weakness have been encouraged by the noises coming from the agency heads nominated by the Trump administration to date. Both incoming Commodity Futures Trading Commission chairman Christopher Giancarlo and newly confirmed Securities and Exchange Commission (SEC) chairman Jay Clayton have stated their intention to eliminate or simplify the existing Dodd-Frank rules.

While it would be relatively straightforward for individual agencies to relax their rules, making substantial revisions to the interagency Volcker rule regulation is a more complex undertaking.

The interagency rule was negotiated between the Treasury Department, the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the SEC and the Office of the Comptroller of the Currency in December 2013.

The rule, which runs to 272 pages in the Federal Register and contains 2,825 footnotes, splits responsibility for monitoring Volcker compliance among the five major US federal regulatory agencies. For instance, at a single bank, the FDIC would be charged with ensuring compliance with the rule at the insured depository institution, the OCC would monitor the positions entered by the national bank, and the SEC would oversee the trading activity of the broker-dealer. Revisions to the interagency regulation would require the co-operation and consent of all five bodies.

By the end of this year, Trump appointees should be firmly installed at the head of four of the five agencies. Fed chair Janet Yellen’s term expires in February 2018, and while President Trump was widely expected to nominate a replacement, he has since said he is open to re-nominating her for another four-year term.

Daniel Tarullo

Whoever fills the vacant role of vice-chairman for supervision at the Fed will also have a big say in any revisions of the Volcker rule. The position was created by Dodd-Frank and assigns responsibility for bank supervision and regulatory matters to a specific governor. It has never been filled, although Tarullo has effectively occupied the role since its inception.

Trump is reportedly planning to nominate Randal Quarles, former undersecretary for domestic finance at the US Treasury during the Bush administration, for the role. Beltway insiders expect Quarles – if confirmed by the Senate – rather than the Fed chair will determine the prudential regulator’s posture on softening the Volcker rule in the coming years.

“We don’t know who is going to be named to take those seats at the Fed, so I would not prejudge that we are necessarily going to see folks appointed who are wedded to making changes around Volcker,” says an attorney for a bank trade association. “We’re going to have to see how that plays out.”

Others say the Fed is unlikely to stand in the way of changes to the Volcker rule, regardless of who is appointed by Trump to fill key seats. “If you go back through the record, you will find very few, if any, statements of support for Volcker from Tarullo, [former Fed chair] Ben Bernanke, Janet Yellen or other agency heads. I don’t think it was ever a rule that any of the regulators truly cared about," says the former Fed staffer.

For his part, Volcker sees little need to make substantial changes to the interagency regulation. Its length, he says, was necessary to provide regulated entities with as much clarity and certainty as possible. “In the US, we have a tradition where you cannot have laws and governance that operate on principles – you need the details,” he says. “You need to know precisely what the legal language is, what is permitted and what is not.”

Volcker also dismisses the argument made by Tarullo in his April 4 speech that the rule, as written, is consuming too many regulatory resources. “The Federal Reserve Bank of New York and the Board of Governors have huge resources they could devote to this subject,” he says. “We are not arguing whether the Volcker rule is too complicated a regulation or not – we just need to look for ways to operate it more simply. There’s no question about that.”

Easing of enforcement

In the absence of any revisions to the trading ban at regulatory level, banks could yet receive informal relief through a relaxed enforcement structure, especially with respect to the extensive reporting requirements associated with the rule. 

The interagency regulation requires each trading desk to report seven trading metrics to their primary regulator on a monthly basis, although the information is collected daily. This data is used to determine: whether inventory is being held to meet expected short-term customer demand; if the positions qualify for a market-making or risk-mitigating hedging exemption; or whether they are intended to make a proprietary gain, which is prohibited under the rule.

Bank compliance officers say the process of harvesting terabytes of data on these metrics from individual trading desks is the most onerous aspect of complying with the Volcker rule.

“Part of our ongoing frustration is with the metrics. At a minimum, the metrics have to be reduced in number and probably changed because some of them are somewhat meaningless in our view,” says an in-house counsel at a large US bank. “Reporting inventory ageing characteristics on derivatives does not make a whole lot of sense.”

Banks suspect the federal regulators are not doing much with the data that is reported. The idea was that regulators would use the metrics to benchmark firms against one another and conduct horizontal reviews to identify activity deviating from the industry-wide average. They could then come back to trading desks with questions about outlier positions to ascertain whether the activity constituted a breach of the Volcker rule or qualified for an exemption.

These questions have not materialised, however, leading two compliance officers at two different US banks to conclude the metrics are being submitted “into a black hole” and not even being looked at by bank examiners.  

Even if somebody was looking at all the data, I don’t think the data alone answers the question of intent
Joel Telpner, Sullivan & Worcester

Joel Telpner, a partner at law firm Sullivan & Worcester in New York, shares this suspicion. “With the reporting as extensive as it is, I think it would be hard to take all the masses of data coming in and use that by itself to determine a firm has complied with the Volcker trading requirement,” he says. “Even if somebody was looking at all the data, I don’t think the data alone answers the question of intent.”

One senior regulator at the OCC disputes this. “Certainly, we look at the information the banks are reporting,” the person says, adding that the Volcker metrics are being analysed for evidence of prohibited activity.

In his parting speech, Tarullo acknowledged the Volcker rule’s reporting regime is not working as regulators had hoped.

“The agencies knew this approach would be complicated when we adopted it, but it seemed the best way to achieve consistency, at least over time,” he said. “I think the hope was that, as the application of the rule and understanding of the metrics resulting from it evolved, it would become easier to use objective data to infer subjective intent. This hasn't happened though. I think we just need to recognise this fact and try something else.”

Trying something else is easier said than done, however. The reporting of quantitative metrics is a requirement embedded in the interagency rule, and any revision to the existing regime would have to be agreed by all five of the Volcker rule regulators.

A legislative repeal

The ideal outcome for opponents of the Volcker rule would be an outright legislative repeal, and Republicans in the House of Representatives are working to make that wish come true. 

In September 2016, Jeb Hensarling, chairman of the House Committee on Financial Services, introduced the Financial Choice Act, which would repeal vast swaths of the Dodd-Frank Act, including the Volcker rule in its entirety.

Hensarling’s office confirmed to Risk.net on April 11 that his revised bill, dubbed the Financial Choice Act 2.0, will retain the language in the original version repealing Section 619 altogether when it is introduced in the House later this month.

The Choice Act appears destined for a smooth passage through the House, but its prospects are more tenuous in the Senate, where the Republicans lack the 60-vote supermajority required to override a filibuster.

Hensarling’s counterpart in the Senate – Mike Crapo, chairman of the Committee on Banking and Urban Affairs – has not offered any public support for the Choice Act and is said to be working on his own bill. 

Mike Crapo

Speaking at a US Chamber of Commerce conference on March 30, Crapo expressed his wish to work in a bipartisan manner “with members of the banking committee, with the administration, with chairman Hensarling in the House, and with regulators to strike a balance between smart, thoughtful regulation and promotion of economic growth”.

Crapo also indicated regulatory reform would take a back seat to tax and housing finance reform in the banking committee’s list of priorities.

“All along we have heard from the new administration that regulatory reform is in the top 10 policy priorities, but not in the top five,” says a regulatory specialist at a bank trade association. “They’ve looked at healthcare and the Supreme Court; next comes tax reform, infrastructure and immigration.”

It appears unlikely that any substantive rollback of the Volcker rule would receive enough support from Democrats in the Senate to get over the 60-vote threshold. Left-wing Democratic senator Elizabeth Warren vigorously denounced the repeal of the notorious swap push-out rule in December 2014 and may rally fellow Democrats to defeat any bill that would do away with the proprietary trading ban.

The confirmation of Neil Gorsuch to the Supreme Court opens up the – albeit remote – possibility that Republicans may be able to ram a Dodd-Frank repeal through on an up or down vote.

The Republican majority voted on April 2 to alter the Senate’s rules in order to confirm Gorsuch, lowering the threshold to approve a Supreme Court nominee from a 60-vote supermajority to a straight majority vote – the so-called “nuclear option”.

The 51-vote majority only applies to nominee confirmations currently, but some lobbyists believe it could be extended to pass legislation. The tough re-election campaigns facing many Senate Democrats in the 2018 mid-terms could motivate a sufficient number to move to the political centre and work with Republicans on a bill repealing some or all of the Volcker rule.

“What happened with the nuclear option is critical, as is the question over whether it gets applied beyond Supreme Court nominees,” says the former Fed staffer turned bank lobbyist. “I have to believe that is not likely, but remember at least 10 Democratic senators are up for re-election in 2018 in states Donald Trump won. Financial services matters tend to be less partisan than on other issues, so they might be willing to work together across the aisle on Dodd-Frank reform.”

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