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The Volcker Rule: Unintended Consequences?

Oct 29, 2015
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SMITH BRAIN TRUST  When the stock market plunged more than 1,000 points in the first minutes of August 25, later rebounding for "only" a 588-point loss that day, did well-intended financial regulations contribute to the volatility? The Dodd-Frank act, passed in the wake of the 2008 financial crisis, introduced a host of regulations into the financial system that were intended to prevent the recurrence of a meltdown.  But some scholars worry that one particular regulation, the so-called Volcker rule, which took banks out of the game of "proprietary trading," may have introduced new uncertainty into the system.

The Volcker rule, proposed by economist and former Fed Chairman Paul Volcker, was intended to prevent banks from making speculative investments that don't benefit their customers.

But to understand what may be happening now, suggests Robert H. Smith School of Business executive-in-residence William Longbrake, envision the world before the financial crisis. Broker-dealers at entities like Lehman Brothers, Morgan Stanley and Goldman Sachs would buy stocks, or Treasury bonds, as they rose or fell; they served, in effect, as middlemen, matching buyers and sellers. If a trade didn't happen immediately, they would hold securities for potential buyers.  "It's the same idea as when a business has an inventory," Longbrake says. "A business keeps things in stock because they are not sure when they are going to get the next order, but they want to be able to fill it right away when they do. In the case of securities, the middleman role of broker-dealers provided market liquidity and stabilized prices."

Of course, the brokers didn't create those markets for altruistic reasons. They were themselves taking positions, or making bets, on the movement of securities, so they were assuming risk. They could get stuck holding the stocks if they continued to plunge. But these intermediaries gave the system a cushion — a sense that there was a buyer of first resort. And even in the absence of a sale, the knowledge that such buyers exist can have a market-calming effect. Or so goes the theory about the link between prop trading and volatility.

A desperate need for access to funding during the financial crisis to finance inventories of securities, however, led investment banks, Goldman Sachs and Morgan Stanley among them, to seek the classification of "bank holding company," which made them eligible for the Fed's discount window. Now the Volcker Rule largely forbids bank holding companies from proprietary trading. The number of institutions actively serving as broker-dealers dwindled as a result, with many traders heading to hedge funds. A few private players persist, but they are too few and too small to serve the buffering role that the larger banks did.

"The regulatory argument was that the Volcker rule was intended to 'de-risk' the system," Longbrake says. "But the consequence of the rule is that when you need someone to take some risk they aren't ready and willing to do it. The upshot is that what we went through in August and September. It has led to more market volatility rather than less. You have no one willing to throw a little water on the fire."

Whether the Volcker rule should be revoked is hardly a black and white question, he cautions, however, because there was plenty of evidence during the financial crisis that banks were not, in fact, always acting in the best interests of their clients. They were issuing market research that steered markets in a way that benefited their financial positions, and they infamously took long-term bets on derivatives backed by subprime mortgages. They took trading positions in derivatives and securities with the intent to profit from price movements. But now we may be seeing the downsides of a world without prop trading. The August volatility "was what you might call a shot across the bow," Longbrake say.

Albert "Pete" Kyle, a Smith School finance professor who, like Longbrake, is affiliated with the Center for Financial Policy, is not persuaded that the proprietary trading does much to dampen volatility in the economy. "When there's a big market move, when the stock market kind of crashes, and the bond market is stressed out because investors are all going the same way, I don't think the prop trading desks have been the ones that have been taking the other side of that," he says. "I think it is hedge funds — and that they have played that role for a long time."

Rather, prop desks "have served as an intermediary between hedge funds and the rest of the economy," Kyle says. They have matched sellers with buyers "on a within-day basis — not bearing the risk from one day to another." To serve as a market buffer, they'd have to be holding those inventories for longer.

While not persuaded by the volatility argument, Kyle is concerned about a different Dodd-Frank regulation that affects proprietary trading desks: Restrictions on leveraging. One role prop trading desks often play is to spot securities that are out of line and to take a long position on one and a short position on another. They will do this when, for example, "off-the-run" 10-year bonds in circulation for a year have become nine-year bonds and are undervalued relative to new 10-year bonds.

That is a very safe bet, but delivers a small return, so high rates of leverage are essential to making them profitable. But Dodd-Frank prevents banks from taking highly leveraged positions no matter how safe the security, so banks are avoiding those arbitrage opportunities. That may be introducing inefficiencies into the Treasury bond market.

Kyle thinks that the piecemeal regulations introduced by Dodd-Frank — capital requirements, leveraging restrictions, bans on prop trading, and stress tests — have created an unduly complex environment for investment banks. That means many trades, even simple ones, are migrating to largely unregulated hedge funds. Much higher capital requirements, he thinks, would have been a simpler way to achieve many of the goals of Dodd-Frank, with less regulatory confusion.

The Smith School's Center for Financial Policy, together with the CFA Institute, is holding a panel discussion on fixed income market liquidity and transparency from 10 a.m. to 3 p.m. Nov. 11 at the Ronald Reagan Building, 1300 Pennsylvania Avenue NW, Washington, DC 20004. The keynote speaker is Larry Harris of the University of Southern California's Marshall School of Business.

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