Volcker rule may not rein in speculation in Wall Street

Various regulators in the United States working together managed to finalise the final version of the Volcker rule on December 10, 2013. The rule is named after the former Chairman of the Federal Reserve, Paul Volcker.

Volcker was the Chairman of the Federal Reserve between 1979 and 1987 and famously raised interest rates to close to 20% in order to kill double digit inflation.

Before understanding what the Volcker rule is, it is important to understand how banks used to operate till a few years back. Banks borrowed money through deposits at a certain rate of interest and lent it out as loans at a higher rate of interest. The difference between the two rates of interest was the money that a bank made. It was as simple as that.But somewhere along the line, banks started to make one way speculative bets on financial assets using their own funds. These bets, referred to as proprietary trading, ballooned in the run up to the financial crisis. As Michael Bobelian writes on Forbes.com"Leading up to the financial crisis, proprietary trading, in which financial institutions invested their own funds, ballooned as it became more lucrative. Those riches also carried with them immense risks that nearly destroyed the financial sector in 2008."

Paul Volcker suggested that banks whose deposits are insured by the Federal Deposit Insurance Corporation(FDIC) in the United States be prohibited from proprietary trading. The idea was to reduce the risk that it built into the financial system, leading to the government and the Federal Reserve having to come to rescue of all and sundry in the end. As Timothy Noah writes on www.msnbc.com “The rule’s overarching goal is to reduce the type of speculation by banks that contributed to the 2008 crisis.”

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But there are certain exemptions that are allowed. Banks are allowed to function as market makers and buy financial securities to meet the demand from their customers. And this is where things start to get interesting.

As John Cassidy writes on www.newyorker.com “There are also exemptions for market-making, in which the banks build up sizable positions in all sorts of securities, supposedly with the sole intention of having enough on hand to meet the demands of clients and for hedging risks taken elsewhere in the firm. But how can any outsider know whether a given trading desk is buying tech stocks, for example, to anticipate customer demand or to wager on the Nasdaq going up?”

What does the Volcker rule have to say with regard to this? It allows banks to buy financial securities to meet “the reasonably expected near-term demands of clients, customers, or counterparties.” The phrase reasonably expected is not defined.

There are also certain situations in which proprietary trading is allowed. “It doesn’t apply to government bonds, including those issued by the federal mortgage agencies and by municipalities. If Goldman or Morgan Stanley want to short Treasury securities, or the city of Chicago, they can go right ahead. Also excluded from the restrictions are physical commodities, such as oil and gold,” writes Cassidy.

Interestingly, a major reason why a lot banks(both investment banks and normal banks) got into trouble around the time the financial crisis first broke out was the fact that they held some of the junkiest subprime mortgage backed securities on their own books, in the hope of making higher returns. These were essentially speculative bets on the housing market in the United States. Cassidy points out that the Volcker rule does not nothing to stop banks from making these bets.

Also, banks are allowed to enter certain trades that may look like proprietary trades, as long as they hedge their bets. But the question is can a differentiation always be made? Neil Irwin of The Washington Post explains this point in great detail on his blog.

Irwin takes the example of bank which has bought options betting that the value of the Brazilian real may fall against the dollar. The regulator may catch on to this and ask the bank “What is this!” you say. “You are speculating that the real will fall against the dollar. You know you aren’t allowed to speculate on currencies under the Volcker Rule.”

The banker though may have a perfect explanation for it, writes Irwin. “What are you talking about? I’m not speculating on the Brazilian currency! I have this huge loan that I made to a Brazilian construction company. And they make all their money in reals. So all I’m doing is guarding myself against the risk that the real falls, and I won’t get my loan repaid. This is reducing the risk that the bank faces, not increasing it!”

Lets understand this in a little more detail. Currently one dollar is worth around 2.34 Brazilian reais (plural of real). Lets say the bank gives a loan of $10 million to a Brazilian construction company. The construction company converts the dollars and gets 23.4 million reais in return. Now lets say, by the time the loan is to be repaid one dollar is worth 5 Brazilian reais. In order to repay the $10 million, the Brazilian construction company will now need 50 million reais ($10 million x 5). It may not have that kind of money and may choose to default totally or partially. This will amount to a huge loss for the American bank. But to take care of this loss the bank has hedged the loan by buying options. And the pay off from the options will make up for the loan losses. Given this, it will be difficult to differentiate between a speculative trade and a hedge in many cases.

One school of argument being currently put forward is that the Volcker rule is already having an impact, given that some of the biggest banks on the Wall Street have already closed down their proprietary trading divisions.

As Kevin Roose writes on www.nymag.com “Goldman Sachs had an entire unit, Goldman Sachs Principal Strategies, designed for prop trading - essentially, betting the firm’s own money on stuff. It was closed, and most of its people moved to a private-equity firm. Morgan Stanley had a prop-trading unit with 60 employees. It got closed, too. So did the prop-trading divisions at Bank of America and Citigroup.”

The conspiracy theory, as a Wall Street veteran told me is that banks are “setting up their traders as “independent” hedge funds.” If this turns out to be true, the overall riskiness of the financial system is unlikely to come down.

To conclude, time will tell how successful the Volcker rule will turn out to be. It might succeed in the short run, but I am doubtful whether it will succeed in the long term. It is worth remembering that the best brains work for the Wall Street, and they will find a way around it.

(Vivek Kaul is a writer. He tweets @kaul_vivek)