The Ghost of Glass-Steagall – A Halloween Horror Story
Banks knocking on the doors of the FDIC, Federal Reserve Board, OCC, and SEC received a 298-page trick in their Halloween baskets this week: the much ballyhooed regulations proposed to implement the Dodd-Frank Act’s Volcker Rule, which prohibits proprietary trading by FDIC-insured institutions and their affiliates. Like a haunted house jack-in-the-box, the CFTC is waiting in the wings.
The stories accompanying the proposal have at times been unnerving. A New York Times headline reads: “With Volcker Rule, Wall Street Braces for Change.” A Bloomberg headline posits: “Volcker Rule Might Reduce Revenue at Fixed-Income Desks by 25%.” And Reuters warns: “Wall Street CEOs may be in Volcker rule crosshairs.” Moody’s said the proposed rules are negative for bondholders of the largest banks. Bloomberg reported that Goldman Sachs and Morgan Stanley may drop their bank holding company status to avoid the proposal’s reporting requirements.
So is the proposal really as bad as all that?
Davis Polk & Wardwell released a 20-page flow chart of the proposal which graphically portrays a compliance department’s worst nightmare. And the proposed reporting and recordkeeping requirements are enough to make Linda Blair’s head spin.
An FDIC-insured institution who, together with its affiliates and subsidiaries, has trading assets and liabilities of at least $1 billion must establish through complex reporting and recordkeeping requirements the fact that it is not engaged in improper proprietary trading. In other words, firms must prove a negative. And a question posed by the regulators asks whether that $1 billion threshold should be eliminated altogether, requiring every FDIC-insured institution with a trading desk to report. Moreover, what constitutes improper proprietary trading is something of a moving target.
Specifically exempted from the proposal’s prohibitions are market making, underwriting, and risk mitigating hedging. What constitutes permissible market making, underwriting and hedging is the billion-dollar question. Welcome to the mirror maze.
In order to identify whether an activity is permitted, the proposal requires insured firms with at least $1 billion in trading assets and liabilities to calculate and report detailed quantitative measurements of their trading activity, by trading unit. The proposed quantitative measurements measure the size and type of revenues generated, and the types of risks taken, by a trading unit. The proposed quantitative measurements also measure revenue and its relationship to risk, the volatility of a trading unit’s profitability, and the extent to which a trading unit trades with customers. The precise scope and detail to be reported would depend on the amount of trading assets and liabilities held by a firm and the type of activities in which each of that firm’s units engage.
The regulators freely admit that the measurements called for by the proposal have never been used for regulatory and compliance purposes. They also freely admit that “additional study and analysis will be required before quantitative measurements may be effectively designed and employed for that purpose.” Comment on the various measurements proposed is requested (and expected). Comment on whether numerical thresholds for the quantitative measurements should be established is also requested. Such numerical thresholds are noticeably absent from the proposal.
The proposal would also mandate that each required quantitative measurement be calculated for each trading day and be reported on a monthly basis. Each firm must also create and retain records documenting the preparation and content of any quantitative measurement it furnishes, as well as such information as is necessary to permit the appropriate regulator to verify the accuracy of the measurements, for a period of five years.
It’s enough to make a CCO run for the safety of Messrs. Glass and Steagall.
Comments on the proposal should be submitted on or before January 13, 2012. View the proposal here.