It was December 10, 2013, and Washington, D.C., was paralyzed by a cataclysmic dusting of snow. While most Washington residents spent the day figuring out how to shovel the overwhelming inch of slush, the leaders of five government agencies joined conference calls, voting to adopt one of the most important financial regulations enacted in decades.
Commentators have been arguing for years about whether the Volcker Rule is a good idea and whether it will work. But nobody seems to have noticed a huge difference between the final rule and the statute as written. This change may enable it to “work,” but not in a way that should please anyone. In fact, it may threaten or eliminate banks’ ability to perform services for which we rely on them — and services that the rule is explicitly supposed to allow. More important, the rule’s final adoption represents the next stage of some of our most disturbing regulatory trends. It may look like a minor storm, in other words, but this is Washington, D.C., we’re talking about.
During the debate over the Dodd-Frank financial-reform bill, the Obama administration endorsed a proposal by former Federal Reserve chairman Paul Volcker that bore his name: Banks that are covered by deposit insurance and able to borrow money from the Fed should not be allowed to engage in trades for their own profit-making purposes. The goal of Volcker’s proposal was to prevent banks from benefiting from government backing while trading for their own accounts. Further adding to the appeal: It was assumed that such proprietary trading is riskier than traditional “safe, boring” banking and that it had contributed to the financial crisis. The idea was often portrayed as a modern version of the Depression-era Glass-Steagall Act, which separated investment banks from commercial banks, and was loosened and eventually repealed during the 1980s and ’90s. Congress adopted the Volcker Rule as Section 619 of Dodd-Frank, but the provision expressly allowed banks to continue underwriting and market-making in securities and hedging their own risks.
By permitting the exempted activities, Congress created a near-impossible situation for regulators. Permitted activities, such as market-making (i.e., standing ready to buy securities from and sell securities to other market participants, which as a practical matter requires the market maker to hold an inventory of such securities on an ongoing basis), involve some of the same operations as the forbidden proprietary trading. Since the statute did not provide bright lines distinguishing the forbidden from the permitted, the regulators writing the final rule could not lay out such bright lines either. Regulators thus had little choice but to flesh out the rule with a more flexible facts-and-circumstances approach. This subjectivity lends itself to great uncertainty about what is permitted, and could lead to constant negotiation with regulators on that question regarding both current and past activities (and thus also is vulnerable to hindsight bias).
The regulators provided as much guidance as they reasonably could. But in the final rule, in order for a trade to qualify as “underwriting,” “market-making,” or “risk-mitigating hedging,” the bank must have a robust compliance program to determine it is one of the three, and exhaustively document why. The chief executive of the bank also must certify that the right compliance process has been followed (but needn’t attest that the trades are actually permitted activities). Compliance processes and procedures are common in tightly regulated industries, and they can be very good things. But uniquely in the Volcker Rule, these processes are not a separate measure to help ensure compliance with an underlying rule, but are rather part of the rule itself. The rule goes beyond the normal complaint that regulators elevate process over substance; it makes process into substance.
About a decade ago, the Sarbanes-Oxley Act was passed to address supposedly rampant corporate malfeasance by imposing extensive procedural requirements on the auditing and operations of public companies. In 2008, the conservative blogger TigerHawk, a senior officer of a publicly traded medical-device company, posted an extraordinary lament about the effects of Sarbanes-Oxley:
Process has come to dominate the management of public companies at the expense of advancing the underlying business. [Sarbanes-Oxley has] driven boards and management to the last defense available to them when tort lawyers or prosecutors come calling, that they ran a good process. . . . In the production of financial statements, [the law] quite literally elevated process — that word again — to the same stature as outcome. Whereas before it was only necessary to produce financial statements that neither misstated nor omitted a material fact and were true in all material respects, now one must do that according to a process that is under “control.”
By elevating compliance processes to an actual component of the criteria that determine whether trades are permitted, the Volcker Rule extends Sarbanes-Oxley’s error.
Of course, by imposing these procedural requirements on every trade, the Volcker Rule makes it that much more expensive and time-consuming to perform transactions, even clearly legal ones. Having extensive and robust procedures in place can insulate a company or board from certain regulatory risks, but there are two vulnerabilities of such a regime. First, even the best-designed processes cannot guarantee that decisions will not look less reasonable in hindsight, or that regulators will not be able to argue as much. Second, those procedures introduce a risk of their own: Regulators can focus on violations of the procedures themselves, not just the underlying conduct the procedures are meant to prevent. To paraphrase Mitt Romney, corporations are human, too: Wherever there are extensive procedures, a close regulatory examination often will reveal a number of mistakes. Trying to make sure those procedures are properly followed diverts a huge amount of time, expense, and manpower for businesses and regulators, leaving less attention to the underlying issues the procedures were set up to prevent.
The final Volcker Rule seems well designed to impose maximum hassle, second-guessing, and legal micromanagement on bank traders. This risks forcing banks to get out of not just proprietary trading but many activities that are supposed to be permitted under Dodd-Frank and the Volcker Rule. Because the compliance process is required to determine whether trades are permitted, its costs will fall on clearly permitted trades, too, raising the expense of activities such as market-making.
Accordingly, discussions over whether the Volcker Rule will “work” are being framed incorrectly. Rather than wondering whether the regulators will manage to prevent proprietary trading as intended, we should ask whether the costs and efforts required to comply with the rule will make it infeasible for banks to continue the activities that are permitted under the law. I believe the answer is likely to be yes. In that respect, the Volcker Rule may very well “work” by making anything remotely resembling proprietary trading — including many important activities — too costly to do.
In the preamble that accompanied the final Volcker Rule, the regulators acknowledged this exact possibility. They responded to it by predicting that other entities would provide services such as market-making if banks abandoned the field.
What’s wrong with that — won’t the market supply other providers? There are two main problems.
The first is that, while publicly available data are limited, market-making is often not a very profitable business anymore, especially in instruments such as publicly traded stocks, thanks to lower trading costs. Many big banks have run large parts of their market-making businesses as a loss leader or other client accommodation. For new entrants to replace the big banks in this function, there will have to be more potential profit there, which may mean an increase in trading costs, after decades of declining prices. This is not progress.
The second problem: Even if forcing the banks out of these activities is a net good, this is far from the right way to accomplish that outcome. Dodd-Frank expressly allowed banks to continue market-making and other such activities. Yet the Volcker Rule may have effectively outlawed activities that it and other laws expressly permit. If Congress wanted to prohibit banks from market-making, it should have passed a law doing so.
The Volcker Rule’s elevation of process over outcome follows in the misguided footsteps of Sarbanes-Oxley. This problem can be corrected, and indeed Congress and the Obama administration have already acted to remove some of Sarbanes-Oxley’s procedural requirements for certain firms. But if American businesses are to thrive, this regulatory trend must be reversed wholesale.
– Mr. Senderowicz is a partner in the financial-services group at the law firm Dechert LLP. The views expressed in this piece are solely his and not necessarily those of the firm or any of its clients, customers, or counterparties.