The so-called Volcker Rule is a financial reform proposal by Paul Volcker, President Obama’s economic advisor. The “Volcker Rule” would bar bank and financial holding companies from putatively high-risk activities like private equity investing, managing hedge funds, and proprietary trading. As the President noted,

“Banks will no longer be allowed to own, invest or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit, unrelated to serving their customers.”

The implications:

• If Goldman Sachs & Morgan Stanley thought it would hurt their bottom line, they can easily avoid it. The rule only applies to depositary institutions so the aforementioned companies  can simply return their tiny deposit base & stop accessing the Fed’s discount window.
• It would reduce liquidity and trading volumes on exchanges
  • It would be impossible to know how much bank trading volume is proprietary versus nonproprietary because it is not identified on arrival at the exchange
  • Morgan Stanley analysts estimated the plan would shave NYSE Euronext’s 2010 earnings by 2%
    • Shave Nasdaq OMX’s earnings 3 percent
• Private equity firms would benefit from less (if not eliminate) competition from banks
• Banks might still be allowed to own hedge funds, private-equity funds, and  money-market funds–as long as they are run for clients, with client money. But, as Bear Stearns showed, firms will bail out its internal hedge funds even when it didn’t legally have to

  • A senior banker put it to a NY Times reporter more bluntly: “I can find a way to say that virtually any trade we make is somehow related to serving one of our clients. They can go ahead and impose the rule on Friday, and I can assure you that by Monday, we’ll find a way around it. Nothing will change unless the definition is ironclad.”

The issue at hand is that it is a real solution to a non-problem. Firms that combine elements of commercial banking, broker-dealers & prop trading can pose systemic hazards but this rule focuses on the least problematic issue–commercial banks are simply not significantly involved in private equity or hedge fund-like investing.

Tony James, president of Blackstone, notes:

I think it’s too vague to know, frankly. I don’t think it’s going to in any way make the system more systemically safe. [...] Prop trading, hard to know how that’s defined, I don’t know how you define the role between what’s hedging and what’s really speculative bets. [...] think it’s one of those admirable goals and I think that will be in the details.”

Instead, according to Naked Capitalism, many of the credit bubbleʼs excesses can be traced to the “shadow banking” sector–the intersection between commercial banking & investment banking business models. “Shadow banks” take illiquid credit and interest rate risk (like commercial banks), but fund themselves principally through the wholesale markets (like investment banks). With lower capital requirements & funding advantages, some estimate it compromises of 60% of the US credit system.  This is the real problem:

While it seems like Congress will reject the Volcker reform, it is possible that similar bills will surface this year.

Source:

http://www.nakedcapitalism.com/2010/02/how-the-volcker-rule-misses-the-shadow-banking-system.html

http://online.barrons.com/article/review.html

http://blogs.reuters.com/financial-regulatory-forum/2010/02/09/us-stock-exchange-heads-take-aim-at-volcker-rule/

http://blogs.reuters.com/felix-salmon/2010/02/03/the-volcker-rules-loopholes/

http://dealbook.blogs.nytimes.com/2010/02/02/davos-bankers-seek-united-message-on-volcker-rule/