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Jul 25th 2015 | NEW YORK
FIVE years is the length of a modern British Parliament and one of Stalin s
economic plans. And apparently, it is the time needed to bring in a new
American financial regulation. When the Dodd-Frank Act was passed in 2010, the
so-called Volcker rule was seen as one of its key provisions. But the rule only
formally became operative on July 21st this year.
The pertinent clause of the Dodd-Frank Act amounts to all of 165 words (with
the key points covered in 40). Two activities are banned: proprietary trading
and ties (through investment and relationships) to hedge and private equity
funds. Putting that into practice involved a collaboration of five regulatory
agencies: the Federal Reserve, the Securities and Exchange Commission, the
Commodity Futures Trading Commission, the Federal Deposit Insurance Commission,
and the Office of the Comptroller of the Currency (OCC). This group produced an
881-page preamble leading to a 76-page rule, all of it written in dense
bureaucratese.
The aim of the rule is to stop banks (and their worldwide affiliates) with
access to American government funds from indulging in speculation and conflicts
of interest. In reality, distinguishing such activities from more beneficial
financial operations has proved daunting. It s impossible for banks to know if
they are completely in compliance with the rule, because there are so many
interpretive questions remaining, says Gabriel Rosenberg of Davis Polk &
Wardwell, a law firm.
Exceptions have been carved out for market-making, risk-mitigation,
underwriting and, ironically, trading American government bonds. Nevertheless,
complying with the rule has forced banks to close or sell whole divisions.
Goldman Sachs has closed down two proprietary trading operations without much
ado, and wound down various funds it co-invested with clients without suffering
any visible calamities. JPMorgan has done the same.
Banks have created compliance systems that can at least provide a justification
for why every single transaction meets the Volcker standard (even if the
justification ultimately proves wanting). This has not been easy. Every time a
bank buys or sells a security it is effectively taking part in a proprietary
trade, and this is also true, for example, when they expand their holdings of
foreign currency in anticipation of demand. Bank examiners will not only have
to judge assets and liabilities, but also intentions. Some foreign banks,
judging that they simply lack the political clout to navigate through such a
complex regulatory environment, have cut back their American operations, to the
delight of their American competitors.
Has this upheaval been worth it? While many provisions of the Dodd-Frank Act
require cost-benefit analysis, the Volcker rule does not because it falls under
an exempt area, the Bank Holding Company Act. The OCC provided some
cost-benefit estimates, which are unsubstantiated but could be the basis of
further investigation.
The benefits, the OCC concludes, are largely unquantifiable, include better
supervision, better risk management, greater safety, fewer conflicts of
interest and the hope that a crisis will be avoided. Compliance costs,
inevitably, come with a more explicit price tag. The OCC reckons the seven
market-making banks (presumably the biggest) will have collectively spent over
$400m in 2014 and a bit less going forward. The OCC s annual supervision costs
would rise by $10m. Another 39 banks it examines would only have additional
explicit costs of several million dollars a year.
The biggest costs, however, like the biggest benefits, are hard to quantify.
There may be less competition for large banks because smaller rivals will want
to avoid the steeper compliance costs. By forcing banks to limit efforts to
make markets in securities only to activities that can be tightly linked to
customers, their inventory of securities had declined, as has been noticed in
the corporate bond markets.
That reduces the possibility of big bank losses in a crunch, but it also
decreases market liquidity. Traditionally, investors have required a higher
return to compensate for holding less liquid securities, raising the cost of
capital for some companies and making it harder for others to raise money.
Perhaps the most likely outcome is that trading shifts to unregulated firms in
the shadow banking sector. Financial risks may not have been extinguished
they may just become harder to spot.