Prior to a critical match in a series in which India was trailing 0-2, a former Indian cricket captain was asked what his strategy would be against the opposing team. His reply was that the team should bat well, bowl well and field well — which is basically what the game is all about.

If one asked bankers what they would need to do to prevent the 2008 financial crisis from recurring, they would probably say that banks should borrow well, lend well and manage funds well. It was the ‘manage funds well’ part that the banks got all wrong in 2008.

There has been a lot of literature on the crisis and how to prevent a recurrence, but the US decided to regulate the banks that created the crisis by proposing the Volcker Rule. To compress the rule into a sentence, it prevents banks from indulging in proprietary trading (trading for their own purpose). After three years of lobbying and negotiations, the rule was finally passed recently by five regulatory bodies in the US.

Hard task for regulators The Volcker rule bans banks from trading to profit for their own accounts, while allowing them to continue making markets for clients. Distinguishing between those two practices has been one of the most difficult tasks for regulators.

Regulators have eased the criteria banks must meet to qualify for the market-making exemption. The trades must not exceed, on an ongoing basis, the reasonably expected near-term demands of clients.

The rule instructs banks to determine that demand based on historical data and other market factors. Further, the rule requires that compensation arrangements not be designed to reward prohibited trading.

Regulators will require banks to demonstrate on an ongoing basis that their trades hedge specific risks to win an exemption from the Volcker rule ban.

The banks must analyse and independently test that a hedge demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks. Banks must provide ongoing recalibration of the hedging activity by the banking entity to ensure it is allowed.

The hedging provision became central to the Volcker rule debate after JP Morgan lost $6.2 billion last year in bets on credit derivatives known as the London Whale.

The trades, conducted in the UK by the bank’s chief investment office and nicknamed for their market impact, were described by JP Morgan executives as a portfolio hedge. The buying and selling of securities backed by a foreign sovereign will not fall under the proprietary trading ban in most circumstances.

That exemption includes securities issued by foreign central banks and applies to US banks with overseas operations as well as foreign firms with affiliates in the US.

The proprietary trading rule seeks to limit banks’ speculative bets in another way: by curbing their investments in private equity, hedge funds and commodity pools.

US banks have already begun cutting their stakes in such funds, and will need to reduce them further to meet the law’s limit of 3 per cent of Tier 1 capital invested in the funds.

The rule tells banks’ boards and top managers that they are responsible for setting and communicating an appropriate culture of compliance.

The centrepiece of the governance changes is a requirement that CEOs annually attest in writing that the company has procedures to establish, maintain, enforce, review, test and modify the compliance programme.

Even in its present form and shape, the Volcker rule is not free of loopholes -— there is no total ban on proprietary trading and there is no mathematical limit on the rule that the trades must not exceed the reasonably expected near-term demands of clients. This open-endedness could result in violations.

India is different The 2008 crisis gave birth to a new tag — ‘too big to fail’, which stated that certain banks and financial institutions are so critical to the economy that the Government should come to their rescue when they are in danger of toppling over.

Luckily, the impact of the 2008 crisis hit India at a macro level and not at the individual bank level —- banks in India did take a hit but it was too small to make them collapse. In keeping with the Indian culture of conservatism, the Reserve Bank of India (RBI) has issued Prudential Norms for classification, valuation and operation of the investment portfolio by banks in India.

The Volcker rule will not apply to India and not impact banks and financial institutions materially. However, the RBI could probably take a cue from the Volcker Rule and insist on a compliance certificate from the top management for trading activity.

This certification makes it easier to nail banks when things go wrong.

( The author is Director, Finance, Ellucian .)

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