Rule, going to vote Tuesday, aims to separate everyday banking from the kinds of high-risk trading that caused the financial crisis
Wall Street is facing tighter scrutiny of its trading activities after US regulators moved on Tuesday to impose stricter rules on the types of trades banks can make following the financial crisis.
The long-delayed “Volcker rule” is aimed at curbing high-risk trading on Wall Street of the kind blamed for triggering the worst financial crisis in living memory. But the rule hit yet another hurdle Tuesday – snow storms closed much of Washington and some staff at the top five US financial regulators looked set to vote on the rule from home.
Five years after the financial crisis, the Volcker rule has become the most controversial element of the Dodd-Frank Act, the largest overhaul of the financial system since the Great Depression.
Many details of the 71-page rule, preceded by about 900 pages of explanatory text, are still to be finalised. But according to those who have seen the final draft, it appears the new legislation will impose tougher requirements in some areas than the banks had first expected.
The rule, named after former Federal Reserve chairman Paul Volcker, aims to crack down on so-called proprietary trading – betting on financial markets for banks' own gain. The rule aims to separate everyday banking from the kinds of high-risk trading that caused the financial crisis.
The rule would curb the number of risks banks can take so that they do not exceed "the reasonably expected near-term demands of customers", the regulators said.
The rule will also tackle so-called portfolio hedging, a practice that was supposed to allow banks to offset risks with investments in other portfolios but which critics charge has been used by Wall Street to hide risky speculative bets. Under the new rule banks will be required to identify the exact risk that is being hedged.
According to the executive summary issued by the US Federal Reserve, Volcker would also prohibit “any banking entity from acquiring or retaining an ownership interest in, or having certain relationships with, a hedge fund or private equity fund,” with some exceptions. It would also require banks to establish an internal compliance programme “designed to help ensure and monitor compliance with the prohibitions and restrictions of the statute and the final rule.”
While the Volcker rule was drawn up in the wake of the financial crisis, it was given fresh impetus last year after JP Morgan Chase’s $6bn losses on the so-called “London whale” trades. The bank contended at the time that the huge risky bets being made in London were meant to hedge risks being taken elsewhere.
Wall Street’s lobbyists have won some key concessions. Some securities linked to foreign sovereign debt – money owned by foreign governments – will be exempt. There will also be exceptions for banks’ market-making desks, as long as traders are not paid in a way that rewards proprietary trading. Wall Street’s bonus culture has been seen by some as a prime cause of excessive risk taking.
“This provision of the Dodd-Frank Act has the important objective of limiting excessive risk-taking by depository institutions and their affiliates,” Federal Reserve chairman Ben Bernanke said in a statement. “The ultimate effectiveness of the rule will depend importantly on supervisors, who will need to find the appropriate balance while providing feedback to the board on how the rule works in practice.”
The rule will not come into force until July 2015 and Wall Street lawyers are now expected to comb through the document looking for loopholes and considering whether to mount a legal challenge.
Oliver Ireland, co-head of financial services practice at Morrison and Foerster, said with such an enormous rule “the devil is very much in the detail.”
“Fundamentally it’s the same rule in that it tries to put an end to prop trading,” he said. But he said he doubted it would be enough to halt the next financial crisis. The rule addresses banking entities – not hedge funds. And even in this case, where risky trades are being limited, Ireland said there was a good case that the wrong issues were being tackled.
“It’s not going to stop ‘too big to fail’. It’s not going to stop banks taking risks. Banks lend money with the expectation of getting it back and that’s fundamentally a risky business,” he said. “This is aimed at trading and if you look back at the last financial crisis that goes back to bad lending practices on mortgages. That happened before anyone had traded anything,” he said.
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