Attack on Volcker Rule Seen Exaggerating Cost of Disruption to Bond Market

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By Yalman Onaran - Jan 18, 2012 12:14 PM ET

That exaggerates the impact of the Volcker rule by assuming it would be as disruptive as the worst recession since World War II, said Senator Jeff Merkley, an Oregon Democrat involved in drafting the original law. Photographer: Bill Clark/CQ Roll Call 

Lobbyists for U.S. banks say a proposed ban on proprietary trading will cost companies and investors more than $350 billion. Some economists and fund managers say the claim is greatly exaggerated.
The impact of the so-called Volcker rule on markets and the economy is being debated at a congressional hearing today, a month before the Feb. 13 deadline for comments on a 298-page plan by regulators to implement the ban. The proposal, championed by former Federal Reserve Chairman Paul Volcker, 84, would constrain the largest banks from betting on investments that could produce big losses.
Lobbying groups, including the Securities Industry and Financial Markets Association, say the narrow definition of what’s allowed under the proposal will curtail the role of banks as market-makers, preventing them from purchasing securities clients want to sell without first finding a buyer. That would reduce liquidity and increase transaction costs for companies, according to an industry-funded study.
“Their fears are greatly exaggerated,” said Simon Johnson, an economics professor at the Massachusetts Institute of Technology scheduled to testify at the House Financial Services Committee hearing. “The industry’s claim ignores the fact that when the largest banks stop doing this kind of trading, somebody else will step in to do it. And we have to weigh those costs against the risk of banks blowing up.”

Lobbying Priority

The potential loss of revenue for banks has made pushing back against the Volcker rule a lobbying priority. Efforts by Sifma and other groups to modify the proposal come as lenders already are making less money buying and selling securities. Trading revenue at JPMorgan Chase & Co., the largest U.S. lender by assets, dropped 18 percent in the fourth quarter, the bank reported last week. Citigroup Inc. (C), the third-largest, posted a 10 percent decline yesterday.
The Volcker rule is scheduled to take effect in July, two years after passage of the Dodd-Frank Act, which incorporated the restrictions. While a final version of the regulation could be published within two to three months of the Feb. 13 deadline, there’s a chance details won’t be ironed out before the July deadline, regulators say.
Two studies of the Volcker rule’s impact on markets, commissioned by Sifma, conducted by consulting firm Oliver Wyman and published last month, don’t mention potential benefits. One report estimated that because investors won’t be able to sell bonds as easily as before, they will lose as much as $315 billion on the value of existing holdings. Borrowing costs for companies selling new debt would rise by $43 billion a year because buyers of debt would demand higher premiums for less- liquid assets, according to the study.

‘Lawyer and Psychiatrist’

The Oliver Wyman report bases its analysis on an academic study that looked at the loss of liquidity during the financial crisis. That exaggerates the impact of the Volcker rule by assuming it would be as disruptive as the worst recession since World War II, said Senator Jeff Merkley, an Oregon Democrat involved in drafting the original law.
“They relied on several faulty assumptions, including cherry-picking data points from the bottom of the financial crisis,” Merkley said in an e-mail.
Fed Governor Daniel Tarullo repeated the same sentiment during his testimony today, calling the Oliver Wyman study “analytic advocacy.”

‘Some Liquidity Impact’

“There might be some liquidity impact on the margins,” Tarullo said. The impact on markets remaining limited “depends on how well regulators do their job implementing the rule and the degree to how much non-regulated firms pick up where others leave it aside.”
Representative Barney Frank, the Massachusetts Democrat who led the Dodd-Frank legislation through the House in 2010 when he was chairman of the committee, questioned the regulators on whether they thought they were able to provide the correct guidelines for distinguishing between prop trading and market making. Tarullo and the others testifying at the hearing all answered affirmatively.
JPMorgan Chief Executive Officer Jamie Dimon, 55, said last week that while he supports the aim of the Volcker rule to prevent excessive risk-taking, regulators have written their proposal too narrowly.
“If you want to be trading, you have to have a lawyer and a psychiatrist sitting next to you determining what was your intent every time you did something,” Dimon said in an interview with CNBC on Jan. 9.

Defining Prop Trading

In their Oct. 11 proposal, the Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Securities and Exchange Commission laid out guidelines for how to distinguish between permitted market- making and proprietary trading. The regulation allows banks to use capital to buy and hold securities temporarily in anticipation of finding a match for the trade later, while banning them from betting on asset prices without consideration of client demand.
Sifma and other lobbying groups say the burden of proving they’re not prop trading falls on the firm, which will raise compliance costs and discourage buying and selling for market- making purposes. Some clients agree. Zane Brown, a fixed-income strategist at Lord Abbett & Co. in Jersey City, New Jersey, said his firm, which manages about $100 billion of assets, already has felt the impact of banks being reluctant to make markets in anticipation of the Volcker rule.

Less Liquidity

“Dealers are less willing to carry inventory,” Brown said in a phone interview. “So liquidity has gotten much worse in the last six to nine months. When they don’t want to carry inventory, we can’t sell big blocks of bonds to them. They want to look for a buyer to match the seller first. That lowers the price because the buyer knows the seller is trying to get out of the position.”
Other fund managers say the reluctance is the result of deteriorating market conditions, not fear of pending rules.
“Since the 2008 crisis, the fear of getting stuck with losses has made the banks less willing to buy less liquid bonds,” said Sean Simko, who manages $7 billion in bonds at SEI Investments Co. in Oaks, Pennsylvania. “With the European crisis getting worse in the second half of last year, the reluctance has increased.”

Bid-Ask Spread

Before the financial crisis, the difference between the market-maker’s bid for buying an investment-grade bond such as one issued by International Business Machines Corp. and the offer for selling it would be 2 or 3 basis points, Simko said. Post-crisis, that bid-ask spread has climbed to 20 to 30 basis points, he said. A basis point is 0.01 percentage point.
Some increased trading cost might be payback for the underpricing of risk before the crisis, said Charles Whitehead, a professor of finance law at Cornell University.
“A little friction in the market can be a good thing to prevent a crisis,” he said in an interview.
Hedge funds could take over the role of market-making from banks, Whitehead said. Still, while the cost of implementing the Volcker rule might not be as high as the Oliver Wyman study predicted, it could exceed the benefits, he said. That’s because by only banning short-term prop trading, the rule doesn’t prevent banks from taking oversize risks with their own money on longer-term investments.
“What caused the crisis was banks holding toxic mortgage securities -- long-term assets -- and financing them with short- term money,” Whitehead said.

Volcker Complaint

The alleged failure of the Volcker rule to address the real causes of the crisis was one of the criticisms cited in a staff memo sent last week to members of the House Financial Services Committee in advance of today’s hearing and obtained by Bloomberg News. The committee’s staff also pointed to displeasure by Volcker with the proposed guidelines.
Republican Representatives Spencer Bachus of Alabama and Randy Neugebauer of Texas, the chairmen of the full committee and the investigations subcommittee, respectively, have opposed the proposal from its inception and have pressured regulators to pull back the scope of the rule.
“If the proposed regulations are implemented in their current form, those regulations will dramatically reduce liquidity across multiple markets, which will in turn make it more expensive for businesses to borrow, invest in research and development and create jobs,” Bachus, along with Republican Representatives Shelley Moore Capito of West Virginia, Scott Garrett of New Jersey and Jeb Hensarling of Texas, wrote in a Dec. 7 letter to regulators.

Volcker Blames Lobbyists

Volcker said in a November speech in Singapore that the rule was too complicated and cumbersome, blaming bank lobbyists. He declined to comment for this story.
Former FDIC Chairman Sheila Bair also criticized the complexity of the proposal drafted by regulators, urging them to throw away everything and start again.
“The regulators should think hard about starting over again with a simple rule based on the underlying economics of the transaction, not on its label or accounting treatment,” Bair said in congressional testimony last month. “If it makes money from the customer paying fees, interest and commissions, it passes. If its profitability or loss is based on market movements, it fails.”
The four regulators who drafted the rule testified in the morning session of today’s hearing. In the afternoon, Douglas J. Peebles, chief investment officer at AllianceBernstein LP, the fund-management unit of French insurer Axa SA, will appear on behalf of Sifma. Mark Standish, president and co-CEO of RBC Capital Markets, will represent the Institute of International Bankers, a lobbying group of foreign banks operating in the U.S. Scott Evans, executive vice president at pension-fund manager TIAA-CREF, also will testify.

Fund Managers

Some fund managers are supporting the banking industry attack on the Volcker rule because they have close business relations, MIT’s Johnson said. Non-financial companies did the same when derivatives regulation was being negotiated in 2010, rallying to the side of banks when their own interests weren’t necessarily aligned with the financial firms, according to people familiar with the discussions then.
Some foreign governments also have criticized the Volcker rule. Canada and Japan sent letters to the U.S. regulators, expressing concern that the trading of their sovereign bonds would suffer if U.S. banks are reluctant to make markets. Congress exempted U.S. Treasuries from the prop-trading ban. Sifma will ask regulators to expand the exemption to other top- rated government bonds such as those issued by Canada, said Rob Toomey, a managing director at the lobbying organization.

Rules ‘Too Onerous’

“Congress’s intent was not to harm market-making, but the rules as proposed by regulators are too onerous,” Toomey said.
Even if the Volcker rule does reduce trading in some markets, that might not be so bad, MIT’s Johnson said.
“There’s probably excessive trading anyway,” he said. “Do we need all this trading for the objective of efficient allocation of capital? Not really. They publish these studies saying the Volcker rule could hurt social interest, but since when did the banks start caring about social interest?”
To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net or @yalman_bn on Twitter
To contact the editor responsible for this story: David Scheer in New York at dscheer@bloomberg.net