Fed faces intense criticism over bank rule

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It’s not a great week to be a regulator at the Federal Reserve. Spurred by a section of the Dodd-Frank financial reform law known as “the Volcker rule,” the Fed has put together a set of rules designed to prohibit banks from investing their own funds, known as “proprietary trading,” set to take effect in July.

But the Fed’s efforts are being met with thousands of pages of critical letters from ordinary citizens, the global finance industry, and Wall Street critics demanding regulators change the rules to make them either more restrictive or more accommodating, depending on who’s doing the writing.

The Volcker rule has its origins in the financial reforms of the Great Depression. Remember that scene from “It’s a Wonderful Life” when all the banks in town have huge lines of angry citizens out front, demanding every dime of their money back? It’s called a bank run, and if you’ve never seen one, it’s because they rarely happen anymore. In times of trouble, banks can now depend on a helping hand from the federal government. This comes in the form of insurance from the Federal Deposit Insurance Corp. and access to money at low rates from the Federal Reserve.

Safety net for banks

Those two safeguards are a big part of why there were no bank runs during the most recent financial crisis. But it also presented a problem to policymakers, who believed having that safety net under banks encouraged them to make risky bets in global markets in the run-up to the financial crisis, leaving taxpayers and responsible banks holding the bag should those bets fail.

“The big banks do have access to the safety net, in the form of the Federal Reserve discount window, and they can rely fairly heavily on insured deposits to fund their activities,” says Jim Barth, co-author of “The Guardians of Finance: Making Regulators Work for Us.” “One has to be sure that banks, to the extent they have access to that safety net, don’t misuse it.”

The Volcker rule, so named because it was suggested by former Federal Reserve Chairman Paul Volcker, attempts to solve that problem by proposing what started as a simple rule: Banks that take deposits can’t invest money for their own gain.

“The prohibition of proprietary trading by the big banks is based upon the notion — I believe the mistaken notion — that proprietary trading contributed in an important way to the most severe financial crisis since the Great Depression,” Barth says.

But during the legislative process, that simple rule quickly ballooned to include a long list of exemptions to protect trading activities that policymakers considered essential to the operation of global markets. Here are some of the key exemptions.

  • Banks can invest their own funds in U.S. Treasuries.
  • Banks can still engage in risk-mitigating hedging activities.
  • Banks can still trade on behalf of customers.

Accommodating those exemptions while keeping the spirit of the law made things difficult for regulators. The Federal Reserve proposal ran to 298 pages, and it still received thousands of pages of criticism from everyone from consumer advocates to foreign banks to financial industry trade groups.

Financial industry objections

It’s not surprising a long list of U.S. and international banks, including U.S. Bank, JPMorgan Chase & Co., Morgan Stanley and PNC Financial, and trade groups such as the American Bankers Association object to the new rule, Barth says.

“Banks like to earn profits, not be prohibited from doing so, which the Volcker rule does in part,” Barth says.

If the rules are implemented as written, many U.S. banks and foreign banks with U.S. subsidiaries will have to spin off their profitable proprietary trading operations and potentially cut a lot of jobs in the financial industry.

But beyond concerns about falling profits and lost jobs, banks raised a number of issues about how the rules would affect international markets for bonds, derivatives and other types of investments. That’s because many banks perform a function called market-making, which is essentially acting as an intermediary between buyers and sellers, Barth says.

Sometimes at the moment a seller wants to unload a particular asset, there are no willing buyers, and vice versa. That can cause large spikes or crashes in the value of an investment because a lack of either buyers or sellers can temporarily send the price of an asset up or down as the few willing buyers and sellers drive a harder bargain, Barth says. Market-makers smooth out those spikes by buying assets and temporarily holding them until willing buyers show up.

Should banks no longer be allowed to engage in market-making, the cost of investing in some types of securities, particularly bonds, will likely go up for consumers because as liquidity shrinks, transaction costs go up, Barth says.

In the end, that could mean higher expense ratios for bond funds and other investments, affecting returns for individual investors over time, he says.

The other major objection is the cost and complexity of complying with the rules. They say the line between proprietary trading and trading on behalf of clients is often blurry, and that it will be difficult to determine whether a trade will run afoul of regulators until after the fact.

A word from consumer advocates

Some of the critical letters sent to the Fed ran in the other direction, with consumer advocates and Wall Street critics expressing criticism over the profusion of loopholes in the rules. Americans for Financial Reform, a coalition of labor, investor, civil rights, community, small-business and senior citizen organizations seeking comprehensive financial reform, wrote one such letter.

“In the proposed rule, the regulators have not placed the statutorily required limitations on permitted capital market activities. Instead, they have gone to some effort to preserve business as usual in important areas,” the coalition says.

Those advocates were joined by a flood of more than 16,500 form letters sent by consumers pushing for the Fed to implement the Volcker rule without any further industry-friendly loopholes.

For his part, the 84-year-old Volcker published a long and detailed defense of the rules.

“The comfort for creditors and others inherent in the ability of institutions engaged in proprietary trading to resort to the federal ‘safety net’ can only tend to encourage greater leverage and risk-taking. Commercial bank proprietary trading is thus at odds with the basic objectives of financial reforms: to reduce excessive risk, to reinforce prudential supervision and to assure the continuity of essential services,” Volcker wrote.

Ultimately for regulators, the decision with how strict or accommodating to make the rules will come down to a cost-benefit analysis, Barth says.

“If it turns out these costs go up to all sorts of investors and people who buy and sell securities, and there’s less liquidity so the costs are higher, what are they getting in return?” he asks. “Are they really getting, for the money that they’re paying, a much less risky banking system? Have systemic risks really declined much?”

The comment period on the Volcker rule ended Monday, Feb. 13. The Fed will take those comments into account as it fine-tunes the rule and issues a final version. It’s scheduled to take effect July 21.