U.S. Volcker Rule Faces Harsh Critics as Date Nears

The following article was published in Bloomberg on February 14, 2012:

U.S. Volcker Rule Faces Harsh Critics

By Cheyenne Hopkins, Silla Brush and Phil Mattingly

The world’s largest banks demanded a wish list of changes to a proposed U.S. ban on proprietary trading, seeking to escalate the lobbying effort against the Volcker rule five months before it takes effect.

In scores of comment letters filed yesterday, bankers and their trade associations said the so-called Volcker rule would increase risk, raise investor costs, hurt U.S. competitiveness and be vulnerable to legal challenge.

“The proposal, if implemented in its current form, will overly restrain our customer-facing market-making business and our risk-mitigating hedging activities to the detriment of our customers,” Colm Kelleher, co-president of Morgan Stanley (MS)’s institutional securities group, and Jim Rosenthal, the firm’s chief operating officer, wrote in a letter posted to the Commodity Futures Trading Commission’s website. “Moreover, we believe that the proposal, if implemented as is, would have severe negative consequence for the markets and the U.S. financial system.”

The rule, named for former Federal Reserve Chairman Paul Volcker, was included in the Dodd-Frank Act to restrict risky trading at banks that operate with federal guarantees. The Fed and three other regulators released the 298-page proposal in October, seeking comment on how it would affect market-making, liquidity, foreign institutions and private equity and hedge fund investments. The CFTC released its proposal separately in January.

Uncertainty, Volatility

Reduced liquidity resulting from the Volcker rule would lead to “price uncertainty, market volatility, higher transaction costs, and a reduced ability for corporations and other market participants to raise capital and hedge their risks,” the Morgan Stanley executives said in their letter.

“Regardless of how the final rule turns out, it will be a shock to the U.S. financial system, as banking entities will need to take extraordinary measures to attempt to implement it,” Barry Zubrow, executive vice president of JPMorgan Chase & Co. wrote in a 67-page letter.

Goldman Sachs Group Inc. (GS) joined its Wall Street rivals in submitting comments by yesterday’s deadline. David Wells, a company spokesman, said Goldman Sachs wouldn’t release or comment on its response, which hadn’t been posted by regulators.

Volcker, who championed the trading restrictions while serving as an adviser to President Barack Obama, defended the regulators’ proposal in his own comment letter yesterday, challenging banks’ arguments that the rule would hurt markets.

“Spectacular’ Losses

“The recent years of financial crisis have seen spectacular trading losses in large commercial and investment banks here and abroad,” said Volcker, 84. “Consequently, the stability of important banks was jeopardized, contributing to a financial crisis of historic dimension.”

The restrictions may limit banks’ trading profits — once a prime source of Wall Street revenue. JPMorgan, Goldman Sachs and Morgan Stanley are among banks that have shuttered or made plans to spin off proprietary trading groups in anticipation of the rule. Citigroup (C) is following suit, closing its Equity Principal Strategies business, according to a memo by Derek Bandeen, the bank’s head of equities, that was obtained by Bloomberg News.

The proposal released in October by the Fed, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency and the Securities and Exchange Commission drew more than 14,000 comments, ranging from a two-page letter of opposition by Michel Barnier, the European Union’s Financial Services Commissioner, to five letters of protest from the Securities Industry and Financial Markets Association totaling 379 pages.

Such an ‘Avalanche’

“I’ve never seen such an avalanche,” said Douglas Landy, a banking partner at law firm Allen & Overy LLP in New York who has been following regulation for 18 years. The Volcker rule has become “the defining fight of this generation” in financial rulemaking, said Landy, whose firm represents Canadian and other foreign banks opposed to the rule.

Officials from Canada, Japan, the United Kingdom and the European Banking Federation sent letters to the U.S. Treasury Department and other regulators saying the measure would harm global liquidity and international cooperation. G-20 leaders haven’t endorsed the rule, which exempts U.S. government debt but not non-U.S. government bonds.

‘Limit the Scope’

Regulators should “limit the scope of the rule only to the territory of the United States,”Barnier wrote. “The current exemption for non-U.S. banks as well as for activities outside of the U.S. would appear very restrictive.”

Stuart Alderoty, senior executive president and general counsel for HSBC Holdings Plc (HSBA), complained that the proposed rule “would apply not only to transactions with a U.S. counterparty, but also to transactions that have limited connections to the United States.”

“As currently drafted,” Alderoty said, “the proposed rule would limit the ability of our Hong Kong affiliate, which is independently capitalized, to purchase for its own account securities traded on a U.S. exchange, or trade for its own account utilizing a U.S. agent to effect a transaction.”

Michael Williams, managing director of Credit Suisse (CSGN) Securities LLC, said the rule could hurt the U.S. economy.

‘Job Losses’

“The practical impact of this narrow interpretation is likely to be reduced liquidity in U.S. markets and securities, migration of trading activities to other financial centers outside of the United States, and the development of alternative trading platforms outside of the United States, all of which are likely to lead to job losses,” Williams wrote.

Bank of America’s fixed income and equities employs more than 1,500 salespeople globally to cover institutional clients, said Edward P. O’Keefe, executive vice president and general counsel. Hedge funds and other non-covered entities are “not scaled for and not in the business of meeting the liquidity demands of customers,” he said.

“Hedge funds are purely proprietary traders,” O’Keefe said. “Covered banking entities, on the other hand, are expected to provide liquidity to their clients, even in distressed markets, and the agencies should not introduce new risks to the economy by assuming that these other unproven and untested sources of liquidity will materialize.”

Two-Year Transition

The Volcker rule is set to take effect in July even if the rule-making is still in progress, and would include a two-year transition period. The Fed would then have the ability to issue one-year implementation extensions on a case-by-case basis.

“I can’t see how they would put all of this into effect by July,” said Joseph Engelhard, senior vice president of Capital Alpha Partners LLC. “There’s no way the banks will have all the infrastructure in place so they will have to delay parts even if they keep it similar to how it is.”

The proposal included a series of exemptions for permissible market-making trading, underwriting and hedging transactions. Lawmakers exempted market-making from the rule, along with certain forms of hedging and underwriting, because of concerns that a broad ban on proprietary trading could bring some U.S. and world markets to a halt.

“The proposal will severely limit banking entities’ ability to hedge their own risk, thereby increasing rather than decreasing the risk to banking entities and the financial system,” the Clearing House Association, American Bankers Association, Sifma and the Financial Services Roundtable said in a joint 173-page letter.

Cost-Benefit Analysis

The industry groups also warned that the cost-benefit analysis in the Volcker rule didn’t meet the standards set in a court case overturning an SEC rule last year. The letter referenced the Business Roundtable’s victory against the SEC, which overturned the so-called proxy access rule because of an inadequate analysis of the costs. The U.S. Court of Appeals in Washington agreed with the U.S. Chamber of Commerce and Business Roundtable.

Regional banks including PNC Financial Services Group Inc. (PNC) and US Bancorp (USB) submitted a letter urging regulators to increase the threshold for Volcker rule compliance to $10 billion from $1 billion to protect trading by firms that weren’t the “principal intended focus” of the measure.

“Because the proposed rules fail to clearly protect such bona fide activities, banking organizations like ours will operate in a continuous zone of uncertainty — unclear whether legitimate activities and trades will on a post-hoc basis be determined by an agency to constitute impermissible proprietary trading,” the companies said in a joint letter that was also signed by Capital One Financial Corp. (COF), SunTrust Banks Inc. (STI), BB&T Corp., Fifth Third Bancorp, Regions Financial Corp. (RF) and KeyCorp.

Not all the comment letters opposed the proposed rule. Senators Carl Levin of Michigan and Jeff Merkley of Oregon, the Democrats who drafted the provision, called the proposal from regulators “too tepid” and said it did “not fulfill the law’s promise.”