Why the Volcker Rule Is Now 3x Longer

23 | By Shah Gilani

Let’s talk about the so-called Volcker Rule.

When the Dodd-Frank Act was signed into law in 2010 – the bank-busting, save the system, “we’ll never again have a financial meltdown that could destroy the world” legislation – it was more of an outline.

The ostensible idea, in the aftermath of the credit crisis, was to give regulators time to write sensible rules and not throw the baby out with the bathwater. Yeah right.

Of course, the real deal was about giving banks and financial services institutions time to fight every rule and regulation, from first drafts to final implementation.

Along the way, it was proposed that banks should spin off their risky businesses into separately capitalized companies, in the form of what an investment bank or a merchant bank used to be. That way they could play hard and fast. And if they failed, tough luck, you’d be on your own. Meantime, the sister bank would have FDIC insurance to cover its depositors and make loans and do traditional bank things. Boring and stuffy bank things.

The Obama administration didn’t go for that. President Obama, for all his bluster about bad banks needing a spanking, didn’t go for that.

Obama advisor Paul Volcker – himself one the most revered and celebrated Federal Reserve Chairmen in the institution’s 100-year history – wanted the separation of gun-slinging banks from insured depository institutions. He suggested banks stop proprietary (or “prop”) trading altogether. (That’s betting the house’s money to make outsized gains to enrich the homeboys who are pulling leveraged levers for fun and profit.)

That suggestion became known as the Volcker Rule.

There’s still no finished Volcker Rule. When I wrote about it 18 months ago, it was 300 pages long (see “Why the Volcker Rule Is a Cop-Out and a Joke“). There’s now a 1,000-page draft circulating with all kinds of marks and bruises all over it. But it’s not done, not nearly done. It’s one rule.

Part of the problem is that banks and bank lobbyists and Congressmen in the banks’ pockets are trying to stymie what they don’t like, meaning the rule itself.

But the bigger problem is this: No fewer than five regulatory agencies are collaborating on the rule.

The Fed and the SEC want to cut banks as wide a highway as they can, so banks aren’t “hindered” from doing what they do that facilitates smooth-running capital markets. The CFTC and the FDIC want to fill in the loopholes being written into the rule. The OCC, they’re clueless anyway, so they’re just reading drafts over lunchtime martinis.

It all comes down to banks wanting to conduct “important functions” – such as market-making and hedging – without stupid restrictions. After all, market-making is not proprietary trading, they say, and hedging, well, that’s hedging, they say.

I was a market-maker (that’s an official stamp) on the Floor of the CBOE. And I was the hedge trader for one of the world’s biggest banks. Let me tell you what market-making is and what hedging is… really.

  • Market-making is when you are supposed to make a two-sided market. It’s your job to simultaneously bid and offer for a stock, an option, a commodity, whatever.

    I’ll use stocks as an example. If you (supposing you’re a broker or dealer or floor trader) ask me for a “quote,” I have to give you a price I would buy the stock at and a price I would sell you the stock at and how much stock I am willing to buy or sell.

    You might want to ask a bunch of market-makers what their quotes are (or these days you see what their quotes are on your computer screen), and you try to buy at the lowest price being offered by some market-maker or sell at the highest price some other market-maker is quoting.

    Market-making is all about taking risks. Market-making is itself proprietary trading. You want to buy stock, and I sell you stock. I did that to facilitate you. But in doing so, I took a position, I sold you stock, maybe I sold you stock I didn’t own, so I shorted the stock to you. I am now short the stock. I have a position. I have on a proprietary trade.

    Let’s say you’re a big customer and you want to buy a ton of stock from me. I will go out and amass a huge position, because I’m going to facilitate you. I’m making a market for you. I’m taking a huge risk building up a position that you said you want to buy. What if you don’t buy that position I’ve built up? What if I made up the fact that I had a customer that I needed to facilitate? What if I just wanted to pretend I was making a market but really wanted to amass a huge position to make money for my trading desk, for my bank, for my bonus pool?

    How on earth are regulators going to know if banks are taking proprietary positions and just calling them client-related positioning or market-making? They aren’t. It’s a giant loophole.

  • Hedging? Let me say this about that. Hedging is when you have an at-risk position and you don’t like the risk. So, instead of just dumping the risk position (which is better than hedging), which you may not be able to do or unwilling to do for any number of reasons, you put on a hedge. A hedge is another position that makes money if your other position loses money. A perfect hedge (which is very hard to accomplish) means you don’t lose any money. You don’t make money, but you don’t lose money. An imperfect hedge will result in you probably losing some money, and once in a blue moon, you can make a little money on a hedge.

    If you’re a bank, though, you can make a ton of money on a hedge, or you can lose a ton of money on a hedge.

    Why? Because you weren’t really hedging. You were saying you were hedging. But you were taking another position with a lot of risk to make money on that part of your hedge.

    You weren’t hedging. You were lying about hedging. You were prop trading.

    That just happened. The JPMorgan “Whale” trade in London, the one that lost them $6.5 billion, that was a “hedge” trade. Yeah, that’s what they called it. It was a hedge trade that went bad. That was a prop trade lipsticked-up and called a hedge trade.

Market-making and hedging are both loopholes. They will be used to prop trade. It’s that simple.

Treasury Secretary Jacob Lew is pushing hard to get the Volcker Rule done by year-end, this year. But the Fed now wants to give banks until July 2015, instead of 2014, to implement whatever it looks like.

If the rule ends up being 1,000 pages, you can guess why it’s that long. It’s that long so that there will be enough fine print loopholes in it to give banks what they want… the ability to prop trade and not call it proprietary trading.

The only thing I can tell you for sure about this pending Volcker Rule is this: When it comes out, I will read it and I will spell out for you where the loopholes are and how banks will use those loopholes.

That much I can promise you.


23 Responses to Why the Volcker Rule Is Now 3x Longer

  1. Tony browne says:

    Your right the Banks have been allowed to gamble the money away, but the intention was to do just that, what people should be asking is why has the system failed and for what reason

  2. Bob Sillcox says:

    If we wish to control risk, why not bring back the Glass-Steagall Act which would separate Commercial Banking (the less risky side of banking) from Investment Banking (the risky side of banking). This would be the simplest way to control banking risk, or am I missing something??

    • Tucsonbilll says:

      Now we see the real damage of the Citizens United ruling. Money has been put front and center. It was bad before. It is horrible now. Glass-Steagall worked for many years. It was repealed by muddy thinking from both political parties. Thus, bi-partisan legislative greed being supported by Supreme Court stupidity. Our government is out of control at every level.
      Now, do you think we have a problem? Is there any question how the nation’s wealth has fallen into the hands of so few? Has any society ever lasted with this formula in place–think the fall of the Roman empire for just one example.

    • fallingman says:

      I get the desire to protect the innocent from rapacious bankers. That said, people act as if Glass-Steagall is some kind of panacea.

      For FUTURE speculation with depositor money … maybe.

      But the horse is already out of the barn. The banks went hogwild, building massive, and I mean massive derivative positions, a fairly hefty percentage of which will be severely marked down or become worthless as counterparty after counterparty fails in domino-like succession.

      And somebody … you … is gonna be bailing out somebody else … the prop traders run amok, GS or no GS.

      Like Goldman getting 100 cents on the dollar back from Little Timmy on its CDS’s when AIG couldn’t pay off on its ill written “insurance.” Because hey, they’re TOO BIG TOO FAIL or even take a loss. There are a lot of “systemically important” institutions out there. And they’ll ALL need bailing out.

      The die has been cast. No GS style legislation has a prayer of being passed, but if it were, it wouldn’t do a thing to stop the approaching meltdown made inevitable by PAST wilding.

      Hang on. 2008 was a warm up.

  3. Myron Martin says:

    Bankers would become far more circumspect about their gambling, (OOPS trading) if by law they were required to absorb losses (personally) if they screw up instead of having the assurance that the government will bail them out at taxpayer expense.

    Isn’t banking a business so WHY should business losses be covered by the taxpayer if practitioners are either stupid or incompetent. There should be a rule that bankers are not allowed to pay themselves bonuses exceeding what they pay to shareholders in dividends, and ZERO bonuses when the bank has a loss.

    Yeah i know, I am dreaming in technicolor expecting such a reform.

    • Sue says:

      Myron – I think you’re right on, but let’s extend it to registered reps as well (& beyond). They only make money if you do, otherwise no commission on any trade whatsoever. I suspect they’d really be trying hard to make you some money!

      I’m a big believer in good ol’ fashioned fair competition. (not price gouging but honest to goodness competition in every area). May the best man (or woman) win.

    • Andy Schuck says:

      Well, weren’t we the cagey ones when GM was bailed out. Oh, yeah, and while we are bailing them out, let’s really screw the bondholders just for grins

  4. kevin says:

    Maybe the answer is to only use banks, which don’t engage in hedging and Market-making. Are there any such Banks nationally?

    • R3P3T3 says:

      Hundreds of them. From credit unions to local banks that have been around for decades. That’s what I use. A first name basis comes pretty quick which sometimes means the difference between getting the “risky” loan or not. If everyone is so peeved by the big banks, then take your money out and crash them. Don’t wait for the dimwits in congress to do what they need to do.

  5. Rick says:

    I love the way you tell it the way it is when it comes to the big banks. Watching what has happened in your banking system has made me really appreciate our system up here in “The Frozen North”, also known as Canada. Their capital requirements are strictly enforced. Consequently it has been over a hundred years since we’ve had a bank failure. Boring maybe, but we sleep well at night.

      • Rick says:

        The two most expensive markets are Toronto and Vancouver, the area I live in. Although prices have increased substantially in the last few years with no apparent end in sight a large percentage of that buying is coming in from offshore. Most are paying cash and the rest are required to have 50% down. The government tightened up lending requirements over the last couple years. In order for a regular citizen to get a mortgage at the best rates they need 20% down, still a pretty sizable chunk. To get a CMHC insured mortgage (equivalent to Freddy or Fanny I believe) you still need a minimum of 10% down. The other stipulation is that your mortgage can’t exceed 30% of your pretax income. There is leeway on that however, especially in Vancouver where 50% is common. Yes, there is still the possibility of defaults, but nowhere near the scale your subprime crisis, or the crash we had in 1980-81 when my brother and I got wiped out for a million dollars when mortgage rates hit 21%.
        Our banks also have investment services but they are completely separate entitties. Eg. TDWaterhouse. You can deal with them at your branch, but everything is separate from your regular banking.
        I have to say that sure hope your banks don’t lead the citizen down the road to ruin again. The people deserve better.

  6. Sue says:

    The banks are certainly running away from taking their ‘medicine’ the Volcker Rule. Sadly, we are
    in so deep now, that Volcker Rule or not, I suspect a future collapse of the economy by 2015 (or sooner) when china and other countries realize that we are not able to repay our debt to them (about 1.2 trillion of our treasuries) and begin buying less of our debt.
    Plus the fact that China is now dealing with many other countries directly (Australia the latest) without first purchasing the US dollar perhaps allowing the yuan to become the new worlds reserve currency. Interesting that a lunar and solar tetrad are occurring almost simultaneously starting April 2, 2014 through Sept 2015. Signs in the Sky? Are we moving towards 3rd world status?

  7. Mister Sprout says:

    Thank you Shaw for the insight. I agree with Tony Browne because we can all see that the banks have been allowed to do this. The Volker rule is another example where permission is given for banks to go greed crazy. This is systemic failure, and it was avoidable. The end result looks like catastrophe from here.

    Knowing where the goal posts are will help us stay in the game… Why has systemic failure been allowed? What is the goal of the mess they are creating?

  8. Stanley Sherman says:

    Re-pass the Glass Steagall act in it’s original form, which created two types of banks, one, an investment bank that could invest or gamble their deposits any way that they liked or, two, a commercial bank that has to generate 95% of it’s profits from lending. Shut the commercial bank down if it doesn’t generate 95% profits from lending. The act was 15 pages long.

  9. Bernard B says:

    The two elected lawbreakers, I mean legislators, Dodd/Frank, put it so many pages in the first place just so that big bank lawyers could find enough loop holes to drive a truck through, (with our money on it of course).

    Imagine just for a moment how many pages our elected lawbreakers would take to explain the 11 commandments. Imagine how much lobbyist money would be spent to water them down or change them completely.

    Always follow the money, as far as our elected lawbreakers, lobbyist money talks, American citizen concerns and our constitution walks.

  10. robert w. says:

    The news is not all bad.
    At least we are not getting Larry Summers, chief repealer of Glass-Steagall, for Fed chief.

  11. Will Harden says:

    My son-in law who is a banker says that,” Dodd- Frank is 2300 pages of contradictory, hard to understand nonsense.”

    All we need is FDR’s best piece of work from 1933 and the mainstay of his intention of never having a depression again. Glass Steagal performed very well until 99 when they repealed it. It took only nine years before the axe fell.

  12. Josephus says:

    I read a lot of comments from publications. My general idea is that there are many educated people who have lost faith in their governments. Most have just clammed up. This leads me to ask about the special interests the NSA and other international spying agencies have on the common intelligent law abiding person. My reasoning and common sense tell me that there is something amiss. There are unseen forces working against each other. Is this a time of the “Tall Poppy Syndrome” ? Will there be Pinochet moment in the US ? 50 years ago JFK happened! People have bad dreams. I pray that the US will awake from this bad dream and heal itself from the money lenders.

  13. Sailor Jo says:

    The “exceptional” people allow to be robbed and cheated and cheer that fact. What is wrong with this country? Are we still in the Wild West?
    There are all these religious nuts but there are no real morals. Great!

  14. Arem says:

    I’m confused. The “trading pit days” are long gone; “HFT” has existed for years & years along with “online brokers” – who have ceaselessly expanded, adapted and innovated to provide GLOBAL investing/trading access (essentially) 24/7/365. This is, truly, the “digital age” – is it not? Why, then, does there remain any need whatsoever for INSTITUTIONAL “market makers”? Obviously “Buyers” and “Sellers” (of securities) still need a “marketplace” through which to meet, transact and settle business, but why must that traditional “middleman” – the INSTITUTIONAL BROKER/”MARKET MAKER” – remain part of the scenario? It seems to me that these traditional INSTITUTIONAL “middlemen” (brokers/market-makers) should simply be eliminated altogether from financial instrument trading/investing markets. Call it a “paradigm shift” (if you must), but I just don’t find any reason/cause (any more) for these traditional “institutional middlemen”. The entire financial securities market GLOBALLY should be moving forward into a DIRECT “buyer/seller interface SERVICE” (only) modality. My take-away from this item by Shah it simply and entirely that what these traditional “meddlemen” (excuse me, “middlemen”) claim/profess to be DOING (in terms of needful, necessary “market-making activities”) is unadulterated crap … rather, what they DO do is manipulate markets and prices for “fees” and “scalps”(to bolster bottom lines and fatten bonus pools) rather than “facilitate market liquidity and price stability”. Instead of WASTING the time/attention of 5 (or even 1) regulatory authority on constructing new rules/regulations a la the Dodd-Frank Act or “Volcker Rule”, simply eliminate the CAUSE for either/both … by which magic the EFFECTS and AFFECTS “vanish”. Once again (it seems to me), we have a (backwards-looking) “government solution” in search of a “problem” that should not even exist any more. And how many MILLIONS USD have been squandered in this futilely stupid attempt to “regulate” those who SHOULD NO LONGER BE “market participants” in any way, shape or form? This entire back-assward “regulatory approach” (and the underlying thoroughly defective mentality that enables it) is explicitly exemplary of why this nation is dying … courtesy of ALL the “unintended and unforeseen consequences” ensuing from the impulsively reactive “legislation” enacted by short-sighted, self-serving politicians who ain’t got no “skin-in-the-game” (due to their own legislated “exemptions”!). [SICK of this,yet? Be patient – Obama has THREE MORE YEARS …]


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