Obama's Volker Rule - Panacea or wrong medicine ?

OBAMA PLAN - Is it panacea or wrong medicine?

The outline of President Obama’s proposals or Volcker Rule as it is labeled, aims to introduce limits on bank size and to restrict proprietary trading. The proposals lack any link to the current financial crisis and will hardly have the desired effect of making the banking system safer.

The core causes of the current crisis viz. poor risk management practices, weak regulatory oversight, loose monetary policies, excess liquidity, investor greed, and rising consumerism will not get addressed with these proposals.

It’s overly simplistic to blame the banks entirely for the current financial crisis. The Central banks around the world kept interest rates too low for too long and topped it with lax regulatory oversight. This was most responsible for the carefree risk taking and desperate hunt for yield that brought the global banking system to its knees. The poison that brought the system down (too much liquidity and lax regulation) has ironically become the cure. The real question is governments are willing to be austere and make individuals / companies face the realities of a deleveraging. If the current low interest rates / weakened currency rates end up driving inflation which it will, it will be too late to rein in the Frankenstein. So the combined impact of deleveraging, higher taxes and higher interest rates would be a real cause of economic pain for some time.

Limiting a bank’s size and its scope of activities will not be a panacea for preventing a systemic failure in the future. The current measures seem like knee jerk reaction to election set backs and misdirected with little likelihood of achieving the intended objective of securing the banking system.

Impact of current proposals

While the devil is in the detail and details are yet to be worked out, here is a quick analysis of potential fall out of current proposals.

Proprietary trading curbs

While what precisely constitutes proprietary trading is still to be defined, it is widely believed that the market making activities to facilitate client business would continue to be allowed.

The plan aims to restrict banks from owning, sponsoring or investing in hedge funds and private equity groups. Whilst these investments were not the reasons for the current financial crisis nevertheless this measure is unlikely to make the system any safer. Banks may still be able to finance these entities and be exposed to the performance risk of these entities. These loans can be structured to give participation linked to performance of the underlying exposure. Hence, this is likely to have a very limited impact.

Restriction on size

The proposal aims to restrict the size of the banks based on market share of retail deposits. While this may limit the extent of the cost of a bail out of an individual financial institution, when there is a market failure, all market participants will be vulnerable to such events. Hence, the overall cost of any future bailout resulting from failure of many smaller institutions will not be any different.

Unintended consequences

The risk of unintended consequences of the current proposals could mean a large part of the financial activity may go into unregulated entities.

Where should the focus be?

Lawmakers’ and regulators efforts will be better served if their focus is directed towards the following issues would yield better results:

• Greater transparency and disclosure of risk positions of banks;
• Overhaul of risk measurement, monitoring and management within financial institutions; most financial institutions cannot monitor risks on an integrated real time basis of all their exposures to a counterparty, this is a major weakness within the financial system;
• Enhance underwriting standards through appropriate regulatory guidelines / oversight; For e.g. Setting income based overall indebtedness limits for individual borrowers and thin capitalization rules for businesses etc.
• Limits on trading activity as a percentage of overall business;
• Conflict of interests with respect to advisory and own positions to be eliminated;
• Asset management business should be divorced from commercial banking as there is a natural conflict of interest; this was the primary cause of origination of assets with poor underwriting standards as banks collected origination fees and transferred the risks to these funds and marketed them to investors; proposed rules on securitization addresses some of these issues;
• Setting appropriate capital measures for trading activities that fully captures stress volatility; as a minimum, trading book capital requirements should be higher than a similar asset in the banking book;
• Focus on Asset Liability management to ensure liquidity, price and Fx risks are appropriately managed;
• Greater transparency on performance based rewards with focus on realised profits rather than a fluctuating unrealized mark to market based results with focus on long term performance of the institution; regulatory developments in this area are progressing along right lines;
• Pro-cyclicality of impairment provisioning and capital requirements to be appropriately addressed;
• Accounting – Simplification of hedge accounting norms.

Conclusion

The Obama plan / Volcker Rule is misdirected and is unlikely to make the system any safer but is certain to yield more than a few filibustering sessions in the Capitol Hill.