Regulation may provoke a second financial crisis

Experts fear unintended consequences from the Volcker rule's banning of proprietary trading, writes Matthew Murphy.

Experts fear unintended consequences from the Volcker rule's banning of proprietary trading, writes Matthew Murphy.

OFF The Wall was wondering at what point I should slip in that this week's topic is about US regulation. Not US regulation in its entirety, but the Volcker rule.

The rule, originally proposed in a 10-page document by former US Federal Reserve chairman Paul Volcker (pictured), is one of the provisions from the Dodd-Frank financial reforms that were drafted in response to the crisis. Basically it says that US banks, including some foreign banks that operate in the US, can't make risky bets with their own money. Volcker proposed to do this by banning proprietary trading. That is what they call it when a company trades stocks, bonds, currencies, commodities or derivatives with its own money to make a profit for itself. Banks would still be able to engage in "market making", which is where they buy and sell assets for clients.

The idea in itself is not a bad one, but unlikely bedfellows are lining up to criticise it.

Obviously the banks are unhappy that the government is taking away a potential trading bonanza. But at the World Economic Forum in Davos last week, foreign governments joined the chorus in an attempt to persuade US Treasury Secretary Timothy Geithner that the Volcker rule will do more harm than good.

The concern of these governments, particularly European powers, is that US banks would be unable to trade foreign government bonds. That would take the US, one of the world's largest bond buyers, out of the market and increase the price of bonds, something the likes of Spain, Italy and Portugal can ill afford.

In reading hundreds of pages on the Volcker rule, including the now swelled 300-page proposal, I found Andrew Ross Sorkin, the author of the book Too Big To Fail, the best at explaining how banning proprietary trading will hit bond markets.

"When a bank sells a 30-year bond from, say, France, the buyer often sells back an older French bond, say a 30-year bond that now has only 22 years left on it," Sorkin explains. "Traditionally, the bank would buy that bond as if it were a used car that was being turned in for a new one. To keep the car dealership analogy going, the bank would then put the used car on its lot until it can find a buyer, with the car or bond in this case sometimes sitting in its inventory for weeks or even months.

"Under the Volcker rule, keeping that car on the lot would constitute a proprietary trade."

The proposal has a special exemption to allow the trading of US debt and securities, meaning it should not cause the same reverberations on the US bond market. The Treasury Department says its modelling of the Volcker rule shows very little effect on the liquidity of foreign markets.

Douglas Elliott, of the Brookings Institution, argues that the main flaw of the legislation it that it focuses on the intent of the investment rather than the risk characteristics.

"By focusing on intent, we are almost certain to miss large swaths of investments that are taken on with an acceptable intent, but still represent excessive risk," he said.

Despite millions of dollars being spent by Wall Street to get the legislation watered down and the proposal still receiving submissions for two more weeks, Citigroup and Goldman Sachs have responded by closing their proprietary trading desks.

That would indicate that the banks have been told that whatever the final version of the Volcker rule actually looks like the ban on proprietary trading stays.

If the Volcker rule does result in increased borrowing costs for European governments then the economic fallout will not be contained to the Continent.

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