A key part of the Dodd-Frank Wall Street Reform and Consumer Protection Act is the Volcker rule. Named after former Federal Reserve chief Paul Volcker, the law aims to reduce risk-taking at banks by prohibiting most proprietary trading and requiring chief executives to be responsible for compliance. Running to nearly than 300 pages of new regulations, the draft Volcker rule has been condemned by major banks for imposing too many regulatory costs. Daniel Ryan, chairman of PricewaterhouseCoopers’ financial services regulatory practice, has been following the rule’s development and its likely impact on Wall Street. He was recently interviewed by senior contributing writer Charles Wallace.
Institutional Investor: How do you think Volcker will affect bank profitability going forward?
Ryan: The rule itself hasn’t been finalized; it is still a proposed rule. We do expect significant changes to the latest draft so it’s an unknown in terms of how the final rule will affect bank profitability. I think the key is that it is going to affect all banks with significant trading activities, both U.S. and foreign. The net has been cast as wide as possible, and it’s going to affect the way in which all the large banks do business. Most of the large U.S. banks had already rid themselves of what they believed to be proprietary trading prior to the recent draft of Volcker being circulated. Prior to the release of the proposed rule, I think that most of those banks would have said the impact of the Volcker rule on their bottom lines would be very negligible because they believe that what they have left is primarily market making. What the surprise has been is what the regulators have defined as market making versus proprietary trading. So now the $64,000 question is, “How will my market-making business change after the Volcker rule is finalized?” The Volcker rule in some ways looks like a call to go back to the good old days of the 1980s, when banking was a much simpler business and banks weren’t heavily involved in many of the capital markets activities that they are today. The tough thing is that the world has changed, the markets have changed, and the role banks play in the markets has changed. I am not sure you can go back in time. That is what everyone is struggling with right now.
Some big institutional investors are concerned that as a result of the Volcker rule they are not going to have sufficient counterparties. Is that a valid concern?
Ryan: I believe that is a valid concern. The equity markets, which are primarily exchange-traded markets, have a lot of price transparency but not always deep liquidity. The fixed-income markets are primarily dealer markets, so they are supported by dealers who hold inventory against buy-side investors wishing to buy and sell. So the way in which the dealers engage with the buy side changes, and so does the extent to which dealers may or may not be able to accumulate or otherwise profit from maintaining large blocks of fixed-income or other securities. As proposed, the rule could certainly have a significant impact on liquidity in the fixed-income and derivatives markets, for example, and result in the widening of spreads and a lack of price transparency.
Fixed income is one area that had been very profitable for Wall Street and is now likely to be substantially curtailed. How will that affect Wall Street’s business model?
The only exemption is really Treasuries and spot foreign exchange and commodities, so only instruments that are in effect cash. To the extent that dealers are not permitted to profit off of their most basic dealing activities, I think the question is, who can take advantage of the fact that the banks are no longer providing the same level of liquidity to the markets? To assume bank profits are going to be harmed means that someone else is going to step in and take advantage of these opportunities, and the way that Dodd-Frank is written, at the moment it’s unclear as to who exactly might benefit from this. Foreign banks are fully impacted by the proposed Volcker rule to the extent that they engage in a transaction that has a U.S. nexus, which means it’s with a U.S. client or a foreign affiliate of a U.S. client or executed on a U.S. exchange. Foreign banks right now are much more concerned about Volcker than U.S. firms, simply because they hadn’t been focusing on it. Smaller U.S. players really don’t have the capital, the balance sheet or the liquidity or funding profile to fully step in and take on the role that the large banks have been playing. What the buy side is concerned about is that if the banks are not going to continue to fulfill this role of market maker, then who is? There probably won’t be new niche players, because when you have $50 billion or more in assets, you get swept into a category that is labeled “systemically important financial institution.” Once you are in that category, the regulators have the right to impose various restrictions on your business, whether it be capital, liquidity or enhanced supervision, and while you wouldn’t necessarily be required to follow Volcker, the regulators could put substantial restrictions on your activities that may be far worse. Ultimately, Volcker will have to be modified to some degree to ease the burden on the banks and try to preserve the negative impact that Volcker could have on the markets. I think the regulators are open to potential solutions. They have asked in their exposure draft, which is 283 pages long, 1,300 questions, most of which talk about what we think the impact is going to be on the markets. We look at that as a bit of a cry for help on the part of the regulators to say, “Please, industry, help us write a better set of rules that conforms to the legislation put forth by Congress.”
What about changes to the trading desks? How will they be transformed so as to comply?
Many of the most basic changes have already occurred at the largest U.S. banks. What a large Wall Street bank typically considered to be a prop desk was a desk that interfaced with Wall Street as a client and was more or less walled off from the basic market-making activities - a desk that was in effect a hedge fund operating within the bank. For the most part, the large banks have exited those businesses or moved them over to the asset management side of their house in the past year, where they will truly operate as hedge funds, with outside investors owning the vast majority of the risk. What exists right now are primarily what, prior to the proposed Volcker rule we would have referred to as market-making desks, where the large majority of the folks on those desks interface with clients or client orders. The way the rule is written, however, those individuals whose primary role is to enhance the profitability of those client orders or manage the risk associated with those client orders could be out of a job, as the proposed rule argues for almost a pure agency model, where a bank would just simply receive a commission or a markup for executing a buy for someone or a sell for someone. The proposed rule doesn’t provide a lot of flexibility with respect to how one might hold securities in inventory in advance of a customer order, manage the risk if the demand is not as anticipated and allow the bank to change their views based on what happens in the marketplace. The proposed rule is written based on the way the Nasdaq equity markets work, not based on the way the fixed-income markets work.
Were there any unexpected regulations when the rule was published?
We thought that there would either be restrictions on activities or a kind of rigid compliance regime, and the rule as proposed has both. Initially, since no one could clearly define what market making was and what proprietary trading was, we thought that they would force banks to put in a strong compliance structure to effectively oversee and attest to the fact that a firm is not prop trading or, alternatively, that they would put in a very specific set of requirements about how to do business, and what we got was that the proposed rule really does both. It puts in specific requirements as to how to do business, and then it also mandates a very extensive compliance regime. At a minimum, the effect of that decision will be higher costs, and potentially it could be higher costs, disruption of business activities and lower revenues. The biggest banks know that this will impact their business, but no one has actually put pen to paper to calculate exactly what impact Volcker could have on their bottom line. The focus now is on improving the final rule.
