As bank regulations go, the Volcker Rule is a doozy. Even if you're not directly involved in financial services, you may feel the impact from this one.
The Volcker Rule, proposed as a regulation under the authority of the Dodd-Frank Act, restricts banks from engaging in proprietary trading. Under the rule, regulated banks will be largely prohibited from taking principal trading positions on their own accounts. There are exceptions, such as market-making, underwriting, and transactions on behalf of customers, but as a guiding principle, banking entities will not be allowed to trade without a valid reason.
Keeping track of those reasons will keep bank IT departments and their technology vendors very busy over the next year or so. Using a series of comprehensive metrics, financial institutions will need to prove that their trading activities are being done at the behest of client requests rather than from self-interested proprietary trading. A banker cannot simply say, "That's a good price, I'll buy it." Instead, he has to finish the sentence: "...on behalf of ."
To monitor compliance, metrics has been proposed using factors such as the timing of revenues, revenue-to-risk metrics, inventory turnover, and the flow of customer-initiated orders relative to all trading orders. Regulators expect that these metrics will enable them to distinguish risky proprietary trading profits from day-to-day profits derived from permitted activities. Again, establishing these metrics will be a major project for IT departments at financial services firms.
As my colleague David Wagner pointed out in an earlier article on this topic, the data-driven requirements of the Volcker Rule will lead to large and significant new projects for bank IT departments. That's the good news.
The bad news is that to the extent that banks shed staff and operations formerly dedicated to proprietary trading, total financial services industry IT headcount and budgets will also be reduced. There may be countervailing hiring activity at newly-formed proprietary trading shops, market infrastructure players, and in other parts of the industry, but the net effect will likely be a decline in overall headcount in financial services IT.
The Volcker Rule will also have an impact outside of the banking industry. Nobody knows for certain how it will shake out, but credible analysts have sketched several eye-opening scenarios: a large reduction in market-making activities, wider spreads on traded instruments, lack of liquidity in the secondary markets for corporate bond issues, and higher cost of capital for issuers of corporate debt. Prominent industry observer Larry Tabb suggests [registration required] that we're returning to the industry structure circa 1980, in that companies will raise money directly from banks' own balance sheets, rather than from issuing tradable swaps and bonds in the capital markets.
If such predictions bear out, the higher cost of capital would put a crimp upon capital expenditures, which in turn -- wait for it -- would lead to downward pressure on IT budgets across the economy, not just in banking.
Yet there's no going back. The global economy paid a huge price for the excesses of the financial services industry, and we haven't finished paying the bill. To ensure that such excesses are not repeated, governments worldwide are reining in the financial services sector, and this, too, will incur a high cost.
Reconstituting the financial sector will take time, energy, and effort, and there will be numerous challenges along the way. Financial services IT departments will be responsible not only for building a robust infrastructure capable of Dodd-Frank compliance, but also integrating those changes alongside of earlier, massive pieces of banking regulation from Sarbanes-Oxley to Gramm-Leach-Bliley. (In a future post, I'll describe the overlap between successive regulatory overhauls of the banking industry and suggest a strategy for IT leadership in compliance.)
At the end of the transition period, we can expect clear delineation between risk-averse banking activities and risk-tolerant securities activities, with transparent markets operating through regulated exchanges. Individual transactions may encounter more "friction" than during the heyday of the financial industry, but as a whole, the system will be safer, sounder, and more resistant to shocks. Once we have a more solid financial infrastructure at the foundation, we should expect a renaissance of innovation, the next time channeled through entities that can be safely allowed to fail.
To my mind, having such a financial system is worth the effort.
What's your take? Do you support the restructuring of the financial services industry along the Volcker model, even if the transition leads to short-term contraction in IT budgets and job opportunities? Let's hear it in the comments.
Let's consider a specific example: Banks selling shares in mortgage-backed securities that they knew were stuffed with impaired collateral, while at the same time shorting those very same securities.
Can you or anyone point to the specific regulation that made this conflicted business model a necessity? At what point did lawmakers chase banks away from their perfectly legitimate trades and businesses, forcing the beleagured bankers, those poor dears, to turn to a life of deception, trickery, and wholesale breach of fiduciary duty to their clients? I'd love to hear it.
My belief is that the technology made bundling and collateralization of mortgage assets possible, and therefore banks proceeded to make money using the best of the available technologies. I also believe there's nothing inherently wrong with a CMO, CDO or other instrument of financial engineering as long as you have precise, accurate, auditable and transparent knowledge of what goes into those complex financial instruments. That didn't happen in this case, and if structured products ever make a comeback, I certainly hope that both banks and their regulators pay more attention to those tiny details in the future.
It sounds to me like your industry contacts are making an implicit threat: If you increase oversight to prevent this category of abuse, we'll come up with something even worse that you haven't yet anticipated.
My response to such threats would be unprintable in a family newspaper. Maybe it's a scare tactic designed to influence public opinion and lawmaker sentiment, or it's something to help them sleep better at night. Either way, not grounded in reality.
@Ivan- i agree. I tprobably is a giant rationalization. But in the hockey situation (as with banks) the knife was banned before the checking rules changed. I think what the banks are saying is that you may have changed the rules, but we still have a job to do so now we're jsut encouraged to do our dirty work when the ref isn't looking. Wouldn't you rather be able to watch us play rough then not be able to watch us play dirty?
And i have to say, I encourage rules about transparency way more than I encourage rules telling people how they can and can't make money.
Sounds like a self-serving rationalization to me. That's like a hockey player saying, "If you won't allow checking into the boards, I'm going to knife this guy instead."
I had a finance professor who came at the question from a different angle, saying something to the effect that there isn't a regulation that can be written that does not admit the possibility of some kind of arbitrage-based loophole. That leads us to a similar vicious cycle.
Perhaps the answer is a principles-based approach rather than a rules-based approach. We see the difference between those approaches in accounting, where US GAAP is rules-based and European IAS (Intl Acct'g Standards) are principles-based. The principles-based approach basically says "don't do anything wrong," which is harder to arbitrage than a system that explicitly lays out a discrete system of rules that can be more easily subverted. The chances of the US switching to that approach are remote.
Or, perhaps we need a rules-based approach backed by regulatory agencies that are equipped to enforce the rules. It's not a fair fight between the IT departments of the masters of the universe vs. poorly-equipped, underpaid bureaucrats working for regulatory agencies subject to "agency capture," where former examiners end up with a cushy bank job if they don't rock the boat. Rules that can be ignored without meaningful consequence tend to become guidelines.
@Ivan- I've spoken to a lot of industry folk who say it is regulation that leads to risky behavior. The story goes like this: Banks will make money the easiest way possible. When they make too much money or the wrong banks fail, government says "no, you can't make money that way." So, they go looking for a more complicated way to make money. Some banks screw that up because it is harder. They fail. Regulation goes in place to keep them from making money that way. Banks looks for yet another way to make money which is even more complicated. Cycle repeats.
Many say that if we went to regulations that told banks simply how much money they could invest and what they needed to reserve, they would stop a lot of their risky behavior.
I think that tends to be an excuse to get rid of regulation. What do you think?
If there are negotiations on implementing a new and improved Volcker Rule, the prospect of having to implement the proposed Volcker Rule may be a powerful cudgel. However, I suspect that the outcome of such negotiations will be delayed (as with legislative action on any front) until after the 2012 election.
As you say Ivan: Keeping track of those reasons will keep bank IT departments and their technology vendors very busy over the next year or so. Using a series of comprehensive metrics, financial institutions will need to prove that their trading activities are being done at the behest of client requests rather than from self-interested proprietary trading. That sounds like a LOT of work -- none of it fun, none of it optional. However, do I think it's worth the effort if it eliminates corrupt, irresponsible financial institutions? Absolutely.
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