The basic premise of the Volcker Rule is laudable: Commercial banks with access to government-insured deposits should not be allowed to speculate in financial markets.

Initiated by Paul Volcker, a former Fed chairman, and backed by President Barack Obama, it was included among the 400-odd rules laid out in the post-2008 Dodd-Frank Act, pertaining to Wall Street reforms and consumer protection.

The transition from a generic principle to a set of specific rules was long-drawn and arduous. The end result — a mammoth 1000-odd page draft which was adopted by five regulatory agencies on December 11 — is at best reasonable; laudable, it definitely isn’t.

Proprietary trading refers to the act of buying or selling financial instruments with the intention of making short-term profits. Permitting banks to place such speculative bets presents a moral hazard. While profits from trades are privatised (as fat bonuses), extreme losses are socialised (as bailouts, with taxpayers’ money).

Volcker called for a ban on proprietary trading as he was convinced that such activities could easily endanger the entire banking system.

Big deal Of all the rules that make up the Dodd-Frank ecosystem, Volcker’s Rule is perhaps the most fiercely debated. This is ascribed to the difficulty in unambiguously classifying trades as proprietary or otherwise.

To clarify, let us consider a simple example.

Assume that a trader buys a Treasury bond. His intent could be to either sell it at a higher price or to satisfy a future buying demand from his clients.

In the first case, he is speculating on a price rise and his activity would constitute proprietary trading. A bank that freely indulges in such activities starts resembling a casino; hence the moniker, “casino banking”.

If the trader’s decision to purchase the bond is in anticipation of future buying demand from his clients, it is deemed market-making.

This activity is less risky as the trader intends to offload his inventory at some future time. Investors also rest easy in the knowledge that there are big players who are willing to absorb their future trading demands.

The economic value of such market-making activities is undeniable.

However, if a regulator has to selectively permit only these trades, he needs to provide definitive criteria for classifying trades as either speculative or market-making.

This is impossible as it depends on the true intent of the trader.

More complex Hedging activities add yet another layer of complexity to trade classification. Banks could hedge their risks at a micro level where the hedge instrument (a financial instrument) is clearly matched to an identifiable risk factor.

Alternatively, banks could also aggregate their risk factors and hedge at a macro level; this practice is also referred to as “portfolio hedging”. Banks strongly urged regulators to permit trades that were identified as portfolio hedges.

However, they were let down by one of their own. In 2012, JP Morgan bank lost more than $6 billion from a trade that its CEO originally dubbed as a hedge.

Activists were concerned that a ban on proprietary trading would not deter banks, as traders could continue their short-term trading activities under the guise of market-making or portfolio hedging.

They recommended that regulators err on the safer side by banning all trading activities.

Banks were obviously troubled. By some accounts, regulators received as many as 20,000 comment letters, most of which came from banks and their allies.

The outcome of this long-drawn battle is at best a compromise solution. Under the final rule, banks are banned from proprietary trading.

The rule also curtails banks’ ability to own hedge funds and private equity firms that engage in such activities.

However, they are allowed to build inventories to meet “the reasonably expected near-term demands of clients, customers, or counterparties” and to hedge “specific and identifiable risks”.

Glaring loophole As might be evident, the wording is precariously imprecise. It leaves substantial room for manoeuvring by exploitative lawyers.

There is no denying that outright speculation would be curtailed. However, trading would continue to prosper under a different name.

It is naïve to think the days of casino banking are over.

The bigger beast lurks elsewhere. If not ably supported by other regulations, the Volcker Rule could actually make banks more unstable.

The ban on proprietary trading activities will have an impact on banks’ bottom line.

A recent research report from Morgan Stanley suggests that this drop could be as high as 20 per cent in certain cases. This naturally translates to a lower return on equity, a metric that banks are constantly struggling to shore up.

To add to their woes, Basel III stipulates that banks should increase their capital base.

Not only will the pie shrink, this reduced portion will now have to be shared among a larger group.

To make their equity attractive to investors, banks will have to resort to extraordinary measures.

We should not be surprised if banks start taking more risk in the banking book.

The onus is then on regulators to ensure that higher capital requirements are strictly enforced and activities such as “optimisation of risk weights” are treated with extreme scepticism.

(The author is Professor of Finance, Institute for Financial Management and Research.)

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