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Financial regulation

Not What Paul Volcker Had in Mind

The Volcker ruleThe Volcker rule, a crucial provision of the Dodd-Frank financial reform law, is supposed to stop banks from doing the sort of risky trading that was one of the big causes of the financial meltdown.

The banks hate the rule because less speculation means less profit and lower bonuses for traders and bank executives. And ever since it was signed into law in mid-2010, they have pressed Congress and regulators to weaken it. Sure enough, in late 2011, regulators issued proposed rules that are ambiguously worded and lack the teeth to rein in the banks. Paul Volcker — the former chairman of the Federal Reserve for whom the rule was named — and other reformers have rightly urged significant changes before the rule becomes final in mid-July. Regulators need to listen.

Here are important changes that must be included:

SPECIFICITY The law prohibits banks from “proprietary trading” — securities’ transactions where the profits and losses are sustained by the bank, not its customers. The sound premise is that taxpayers, who back the banks, should not be on the hook for speculation that mainly enriches traders and bank executives. So that banks can continue to serve customers, the law instructs regulators to allow certain forms of non-proprietary trading, including “market making,” in which banks can buy and sell securities, but only for the purpose of facilitating transactions for clients. The proposed regulations fail to adequately distinguish between the two types of trades. That could allow banks to engage in proprietary trades under the guise of market making.

Under a strong Volcker rule, banks would be barred from amassing complex securities for resale later at a higher price The regulations must also clearly limit the pay of bank market makers to spreads, fees and commissions — and not a share of profits. Until that happens, traders will continue to have strong incentives to engage in prohibited, high-risk trades.

The proposed regulations also do not impose additional leverage and liquidity requirements on banks that engage in permissible securities trading. That is essential to prevent the big losses and fire sales that occurred during the crisis.

RISK, FAST AND SLOW To limit speculation, the proposed regulations advise banks to avoid short-term trading. But they fail to specifically ban broader trading strategies, like the high-frequency trading that was implicated in the infamous flash crash of 2010 and that has become a profitable source of banks’ proprietary trading.

Some advocates also warn that the regulations could still be read as allowing proprietary trading that is longer term in nature, including high-risk arbitrage trades that attempt to profit on price differences among similar assets. The regulations should clearly convey when and how arbitrage would represent impermissible proprietary trading. Otherwise, they could create a loophole for activity that is supposed to be banned.

PENALTIES The proposed regulations lack clear, stiff penalties, beyond threats that banks found to be engaged in proprietary trading will be forced to stop. They also need to clearly define and punish conflicts of interest that arise when banks cross the line into proprietary trading while at the same time purporting to serve as a middleman for clients.

The Volcker rule is not as complicated as banks so eagerly claim. What is complicated is standing up to the banks, who are determined to do everything they can to preserve their high profits, no matter the risk. President Obama, who endorsed the Volcker rule, needs to stand up for it. And regulators need to stand up to the banks and their lobbyists and implement the law.

Source: New York Times

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