A Conversation with Paul Volcker

In a night out that only a compliance geek would love, I spent Monday night listening to Malcolm Salter talk with Paul Volcker, former Chairman of the Federal Reserve. Harvard University’s Edmond J. Safra Center for Ethics and the Center’s director, Lawrence Lessig, hosted the event in the Ames Courtroom at Harvard Law School. The topic, as you might expect, was Implementing Financial Reform

It was clear that Mr. Volcker is a supporter of traditional commercial banking. He stated that they are essential to commerce. Their core functions of taking deposits, making loans, and operating the payment system are essential and need to be protected. There is a price for that protection: government oversight and restrictions.

The 2008 crisis came from non-banks. Hedge funds and investment banks touted their efficiency, lack of regulatory oversight, brilliant managers, and best financial engineers. In 1998 they invented Credit Default Swaps. They blew themselves up.

There were $60 trillion of CDS instruments insuring $6 trillion of loans. Today there are $700 trillion of the greater category of derivatives.  That is an order of magnitude larger that the world’s GDP.

Mr. Volker was quick to point out that proprietary trading was not the cause of the 2008 crisis, it was the origination of many, many bad home loans to people who could not repay them. However, proprietary trading did play a role.

Mr. Salter pulled out a thick binder contained the proposed Volcker Rule. (I did the same thing at the PEI CFO Forum.) But Mr. Volcker found that disingenuous. The rule itself is only about 35 pages and the rest of the binder contained the commentary and thousands of questions posed by regulators.

Mr. Volcker compared the current rule on proprietary trading to a rule on Truth in Lending that he implemented while he was Chairman of the Federal Reserve. The initial draft from his staff was 170 pages, he sent it back with a requirement that it be no more than 100 pages. He wanted it simpler and they delivered. To his surprise, most of the industry comments were to have more details in the rule.

It became apparent to me that Mr. Volcker was advocate of a principle-based oversight rather than a rules-based oversight. The more rules there are, the more gamesmanship that the industry will engage in. He pointed to the example of Barclays and Deutsche Bank re-shaping their US subsidiaries so they would no longer be classified as bank holding companies. He thinks it will be relatively easy for regulators to spot proprietary trading by focusing on volume an volatility.

Switching topics, Mr. Volcker pointed out that the standards for bank capital requirements were another part of the 2008 crisis. Under the regulatory capital requirements, banks were not required to set much capital aside for mortgages and sovereign debt.  There is some backlash in the Volcker rule because it allows proprietary trading in US government securities, but not in non-US sovereign debt. That has been the case for many years, going back to Glass-Steagall. The problem is drawing the line between which sovereign debt is safe and which is not.

Mr. Volcker does not think that the proposed rule is on a deathwatch. Rule-making is inherently complex and this is a complex area. To add to the complexity, several government agencies are involved in the rule. He also pointed out that much more lobbying and money is involved in the rule-making process than when he was Chairman of the Fed. You want industry responses to rules. The difficult part is when that response is coupled with a campaign contribution to Congress.

Circling back to the ethics aspect (the event was sponsored by the Center for Ethics), Mr. Volcker pointed out that proprietary trading causes an inherent conflict of interest with your customers. The trader is no longer acting as a broker, pulling a buyer and seller together. The proprietary trading bank is buying and selling for its inventory.

Proprietary trading creates a conflict in the compensation structure. Traders get paid on short-term gains, often before the trade’s economic effect is fully realized. That outsized and short-term compensation becomes a siren song for bankers looking for fatter wallets, causing them to take bigger risks. (Like, say originating sub-prime loans and reselling them.)

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Comment Period Extended for Volcker Rule

The Securities and Exchange Commission and federal banking regulators have extended the comment period on the Volcker Rule proposed regulations from January 13, 2012 to February 13, 2012. In Release No. 34-66057, the regulators noted that the extension of the comment period is appropriate “due to the complexity of the issues involved and to facilitate coordination of the rulemaking among the responsible agencies as provided in section 619 of the Dodd-Frank Act.” The proposed rule was released in October. The Volcker Rule is scheduled to go into effect July 21, 2012.

The extension’s Release cites comment letters from the Center for Capital Markets Competitiveness of the U.S. Chamber of Commerce (November 17, 2011); American Bankers Association et al. (November 30, 2011); and Representative Neugebauer (R-TX) (December 20, 2011). The ABA letter points out the 1400 questions asked in the proposed regulations.

The Dodd-Frank Act put the Volcker Rule in place to restrict the ability of bank and non-bank financial companies to engage in proprietary trading and to limit their ability to have interests in, or relationships with, a hedge fund or private equity fund.  The concept is simple, but difficult in execution. All banks and financial institutions engage in some form of proprietary trading to hedge the risks in their loan portfolios. Add in the extensive use of securitizations. Sprinkle in the decision by the remaining Wall Street firms to become bank holding companies after the 2008 crisis to get part of the bailout. Whip it all up with the difficulties in defining a non-bank financial company.

Feel free to add handfuls of industry lobbying to the mix, depending on your level of cynicism.  For example, Representative Schweikert is asking the regulators to exclude venture capital investing under Section (d)(1)(J)

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