The 2008 sub-prime crisis, which saw the failure of many big banks, like Lehman Brothers, led the entire world blaming the regulators of US, for their negligent regulation on excessive risk-taking practices that led to collapse of the entire financial system. In the light of the crisis that led to Federal bailouts for many banks, the US President Barack Obama pushed for greater financial regulatory reforms. The former Federal Reserve Chairman, Paul A Volcker, drafted the Volcker Rule, as a part of 2010 Dodd-Frank Financial Reform.
The Volcker Rule would restrict the ability of banks whose deposits are federally insured from trading for their own benefit. The rule would prohibit the banks from Proprietary Trading (i.e., using their own money to place directional market bets that are unrelated to serving customers), and investing their own money in Hedge Funds and Private Equity operations. The rule is applicable to the Bank Holding companies. In 2008, many financial Institutions of Wall Street decided to convert themselves to Bank-Holding companies, to avail the Fed-discount window and become eligible for Troubled Assets relief Program (TARP) and other emergency lending facilities by Fed. At the same time, they came under greater regulation. Hence, this rule becomes applicable to many Wall Street Financial Institutions.
The first draft was introduced in October, 2011. It provides for exemptions to banks for market-making and hedging for risk. Market-making is trading that a financial firm undertakes on behalf of its customers or to keep a specific market functioning fluidly. A marketer maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order.
All the major financial institutions expressed their concerns over the new regulations, saying that they were too costly and complex. They have been lobbying for more exemptions. While the proponents of the stricter regulation have been demanding that only hedging related to a specific position, or a customer, should be exempted, the Financial Institutions have been demanding that broader hedges related to the risk of company as a whole should also be exempted. Another concern is how to draw the line whether the company is trading for genuine market making or trading for its own benefit.
The recent loss of $2 bn in synthetic credit derivatives trading by JP Morgan, which they describe as broad hedging for overall risk of the company, further bolsters the case for stricter regulations under the Volcker’s Rule.
At a round-table hosted by US Commodities and Futures Trading Commission (CFTC) on May 31, 2012, Former Federal Deposit Insurance Corp. Chairman Sheila Bair said regulators should push derivatives out of federally backed banks and tighten the hedging exemption of the still-unfinished rule. She suggested that under Volcker’s Rule, banks should publicly disclose their hedges and continuously disclose how these hedges are performing. Her idea is that hedging is for minimizing risk and not generating profit. A good hedge should lose money.
At the same time, banks continued to argue that a very narrowly defined exemption would damage liquidity by discouraging banks from making markets and hedging risk. Shawn Johnson, investment committee chairman of State Street Global Advisors believes that a diversified bank is a safer bank. He believes that banks would become more vulnerable to crises if they "go backwards" and concentrate primarily on taking deposits and making loans, to avoid violating a tough Volcker rule. Banks also argue that they need the ability to trade derivatives and other products in order to serve clients. They also argue that just because a hedge centre made profit for a month or a quarter doesn’t mean that it’s a profit-making centre.
While the debate is on, it seems that the Volcker Rule, which was slated to be finalized by July, 2012 might miss its deadline. We can only hope that despite delays the rule that is finalized is in the best interests of the economy.