How will the Volcker rule impact capital markets?

Richard Manuel, CFA, Senior Analyst | January 6, 2014

  • Fears that Volcker Rule would impair the functioning of our capital markets were overblown
  • In the final rule, the Fed struck the right balance and allowed current market making practices to continue
  • The true impact of the Volcker Rule will be only discernable over time

Last month, the Financial Stability Operating Committee (FSOC) finalized the last major piece of regulation called for in the Dodd-Frank Act. The Volcker Rule, named after the highly regarded former Federal Reserve Board Chairman, sought to eliminate commercial banks’ proprietary trading activity, which Chairman Volcker believed to be one of the causes of the Global Financial Crisis. In the period between the Dodd-Frank introduction of the Volcker Rule and the final language of the bill, there was great consternation in the industry – warnings that it would impair the proper functioning of our capital markets and produce an uneven playing field for U.S. firms, making them less competitive in global markets. With the final rule out, though some uncertainty remains, it seems that tragedy was averted and that our capital markets will continue to thrive.

There has been considerable debate as to the role proprietary (“prop”) trading played in the crisis. In response, the Government Accounting Office (GAO) did a study to scale the degree to which the largest five U.S. banks’ profits relied on prop trading.

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Notes: Data shown here on stand-alone proprietary trading—which is conducted at desks that are organized by a banking entity with the specific purpose of trading a firm’s own capital—does not include other proprietary trading activities that may have taken place at the institutions, depending on how the term is defined as part of the rulemaking to implement Section 619 of the act. One of the six bank holding companies was responsible for both the largest quarterly revenue at any single firm from stand-alone proprietary trading since 2006, which was $1.2 billion, and the two largest single firm quarterly losses of $8.7 billion and $1.9 billion.

The GAO report found that while proprietary losses were magnified during the crisis, largely wiping out profits over the study’s horizon, the total net impact on the biggest banks’ profits was insignificant relative to the size of the banks and the losses generated by their core lending. Nonetheless, the Volcker Rule aimed to eliminate the perception of risky trading, simplify the regulators’ supervisory effort and stifle the culture of personal greed on trading floors.

Regulators, in drafting the Volcker Rule, needed to distinguish between proprietary trading which is prohibited under Volcker, and true market making trading, which is critical to efficient capital markets. Industry participants felt that the initial drafts of the Volcker Rule were too restrictive; the Federal Reserve (the Fed) received over 15,000 critical comment letters. In the final rule, the Fed managed to strike the right balance, and current market making practices will be permitted. For example, while the original proposed rule included cumbersome administrative documentation of trade “motivation”, the final rule reduced data collection to 7 metrics from 17, and appears to be largely in line with current industry practices.

Critics note a troubling reduction in dealer inventory levels, a sign that dealers are no longer holding as many securities in their capacity as market makers. However, there have been many other regulatory changes beyond Volcker that serve to discourage banks from holding inventory.

Dealer inventory as a percentage of debt outstanding

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Source: Bloomberg, November 2013

Despite the reduction in inventory levels, the fixed-income markets have been functioning rather efficiently. However, it might by premature to declare victory. Over the last several years, fixed-income markets have enjoyed a backdrop of falling interest rates along with healthy issuance of new securities. With dealer reduced willingness to hold inventory, the real test of the Volcker Rule’s impact on liquidity will be when rates are rising, when sellers outnumber buyers.

The impact on investment banks is unclear. One could argue that the Volcker Rule might help capital markets companies by protecting them from themselves, by limiting their risk appetite, and thus by averting the next financial crisis. To believe this, though, one would have to share Chairman Volcker’s personal view that prop trading directly contributed to the crisis. However, the GAO report shows that true prop trading was never a big driver of results, so it would stand to reason that eliminating prop trading should neither hurt nor help the banks.

Certainly, the Volcker Rule has forced technology and compliance expenses to increase significantly, driving lower returns on equity (ROE). Economic theory would suggest that as the cost to compete rises, fewer competitors will remain in the industry, and that with this consolidation, the profits will rise for those that remain. While some players have exited, pricing has not yet improved as reflected in bid/ask spreads.

Bid-ask spread — Five-year historicals

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Source: Bloomberg, November 2013

Markets and market participants prefer clarity to uncertainty. For the last five years, the capital markets have been bracing for a Volcker Rule that everyone feared would diminish the liquidity of the markets. While calmer heads prevailed in the final writing of the law, there still remains uncertainty. Now with a final rule, the companies can construct strategies to adapt, and those with the best strategy could be good investments. Critics’ initial cries of concern seem overwrought, but the true impact of the Volcker Rule will be only discernable over time, when all of the unintended consequences have a chance to show themselves.

 

Richard Manuel

CFA, Senior Analyst
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