Regulators to Set Forth Volcker Rule

By EDWARD WYATT Published: October 10, 2011

WASHINGTON — The outlines of the Volcker Rule, one of the flagship provisions of the sweeping financial regulatory overhaul passed last year, will begin to take shape this week as regulators propose rules to limit the ability of most banks and Wall Street firms to use their own funds to buy and sell stocks, corporate bonds and derivatives. The proposed rules would allow firms to do so in areas where regulators believe healthy markets would not exist without Wall Street’s own trading, including the markets for government bonds, commodities and foreign currencies. And some otherwise-forbidden bets would be allowed only if they are used as a hedge, to keep a Wall Street firm from losing money on a transaction made to accommodate a customer’s trading. But most trades that Wall Street firms now make with their own money — betting on an individual stock or a basket of shares, for example, or trading complex derivatives and swaps — would be prohibited. The rules, part of the Dodd-Frank law, are intended to limit the ability of banks that have government guarantees and Federal Reserve borrowing privileges to take outsize risks. That principle seemed fairly simple when it was proposed last year by Paul A. Volcker, the former Federal Reserve chairman who was a sharp critic of bank trading practices leading up to the financial crisis. But as a 205-page draft of the proposed rules demonstrates, it is more difficult to draw up restrictions that rein in risky trading practices on Wall Street without also killing the ability of beneficial financial markets to operate. People on both sides of the issue have found things to like and dislike. “There are some encouraging signs in the draft,” Bartlett Naylor, a financial policy advocate for Public Citizen, a pro-consumer group, said in an interview. But, he added, “it doesn’t completely eliminate some of the mischief we saw” in the run-up to the financial crisis. Randy Snook, executive vice president for business policies and practices at the Securities Industry and Financial Markets Association, the Wall Street trade group, says that while the draft contains some common-sense restrictions on trading by banks, “our concern is that the list of permitted activities might be too narrow.” The draft, which was dated Sept. 30 and published by the American Banker last week, might be significantly different from what is officially released later this month by the four agencies that are working on the rules: the Office of the Comptroller of the Currency, the Federal Reserve, the

Securities and Exchange Commission and the Federal Deposit Insurance Corporation. The F.D.I.C. on Tuesday will be the first to release a version of the rules for a 60-day public comment. The draft document contains hundreds of questions on which the agencies will seek comments — a sign that “suggests disagreement among agencies” on some of the details, according to lawyers at Davis Polk & Wardwell, which prepared a memo for clients last week summarizing the rules. The most fundamental of those disagreements is likely to be where the line should be drawn between bona fide market-making activity, where a bank’s traders offer to buy and sell a security to meet the trading desires of customers, and short-term trading with the bank acting as a principal in transactions solely for its own benefit. That could be a particular problem in the corporate bond market, analysts say. Companies usually have one class of equity shares outstanding, and at any given time dozens of investment firms might be offering to buy and sell the stock. But the same company could have hundreds of different bonds outstanding, many of which trade infrequently, if at all. If a bank’s trading desk offers to take the other side of a transaction desired by a firm’s customer, determining whether that is a short-term trade for the bank’s own benefit or real market-making is a judgment call. According to the draft rules, the volume and risk associated with such a trade must be “proportionate to historical customer liquidity and investment needs.” That would suggest that a firm that has not previously bought and sold a security could not start doing so — a stance that could significantly limit trading in many corporate bonds. And if investors believe it might be difficult in future years to trade a company’s bonds, its ability to raise money to invest in its business could be difficult. “If the market-making definition is too narrow, that kind of activity will be curtailed,” Mr. Snook, of the securities industry group, said. “That will cause the cost of financing to go up, restrict the ability of companies to get access to capital and therefore to hire and expand.” Nr. Naylor of Public Citizen says there should be further limits on market-making activity, especially on “the sort of thinly traded, esoteric instruments for which there is not natural demand” — like some of the collateralized debt obligations and other derivatives whose collapse contributed to the financial crisis. Moody’s said on Monday that if the draft that surfaced last week was not significantly changed before it became final, it would probably “diminish the flexibility and profitability of banks’ valuable market-making operations and place them at a competitive disadvantage to firms not constrained by the rule.” Specifically, that means offshore banks and investment firms. There are restrictions against American banks moving otherwise-restricted operations offshore. But banks that do not have

subsidiaries operating in the United States can continue to trade freely, both for themselves and on behalf of clients. A lawyer at one large firm that specializes in the financial business, who spoke on the condition of anonymity because she did not want to bring regulators’ attention to her clients, said that that competitive disadvantage could begin to erode New York City’s importance as a financial center and help the fortunes of offshore banks based in London, Dubai, Hong Kong and elsewhere. Still others note that the proposed rules call for a significant increase in the level of internal compliance and oversight at banks, something that will discourage the casino culture that has long pervaded the proprietary trading operations of large banks. Large firms could be required to provide to regulators as many as 22 separate metrics or gauges of investment activity each month to prove that they are playing by the rules. The regulatory staff who worked on the rules would not comment until the document is formally released. Whether the proposed rules will satisfy Mr. Volcker, who called for the end of “essentially speculative activities” by banks, is unclear. He has declined to comment until an official version of the proposed rules is released.