Industries Banking/Finance

Who’s afraid of the Volcker rule?

$5.8 billion trading loss raises questions about the effect of new regulations

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Print this page by Robert Burke

It’s been two years since the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law, bringing major regulatory changes to the banking industry. Yet it’s still not clear what the law’s impact will be, and that worries bankers everywhere, including people like Bruce Whitehurst, president and CEO of the Virginia Bankers Association. “It is a monster, in scope and size,” he says.

Dodd-Frank is a complicated piece of legislation. It was written in response to the financial crisis that began in 2007 with the collapse of the housing sector and led to the $700 billion Troubled Asset Relief Program (TARP) to bail out the imploding U.S. financial system. (The legislation gets its colloquial name from its Democratic sponsors, former Connecticut Sen. Chris Dodd and Massachusetts Rep. Barney Frank.)

The law’s supporters say, in general, that it’s designed to bring more transparency and stronger consumer protections. But hundreds of regulations still are being written, many of them months behind schedule, which frustrates supporters and opponents alike.

Among its more significant and controversial elements is the Volcker Rule, named for former Federal Reserve Chairman Paul Volcker. This rule, which was scheduled to take effect July 21, would, in general, forbid banks from taking part in certain kinds of speculative trading activities. The Volcker Rule “was very controversial even when Dodd-Frank was being debated,” Whitehurst says.

But it’s a tough time to be arguing for less regulation. In mid-June, Jamie Dimon, CEO and chairman of JPMorgan Chase, appeared before the Senate Banking Committee to make his mea culpa for his firm’s recent $5.8 billion trading loss. The loss resulted from a trade involving corporate credit default swaps, which pay off if a company can’t keep up with its debt payments.

Dimon acknowledged in testimony that the Volcker Rule might have stopped the trading activity but blamed the loss on mismanagement, not the lack of regulation. The company said the loss came from a hedge. A week later, Federal Reserve Chairman Ben Bernanke said the Volcker Rule might have helped prevent the loss simply by requiring JPMorgan to document details of the proposed trades.

So the fuzziness over how the rule hypothetically might apply reaches the highest levels of government and the private sector. In fact the complexity of Dodd-Frank produces a lot of cautious comments, Whitehurst says. 

Even before Bernanke’s comments, uncertainty over the Volcker Rule was in place just weeks before its implementation. Executives at several of the major banks in Virginia declined to talk about the law’s potential impact. Even Whitehurst at the VBA says his group is “coordinating our response on this” with the American Bankers Association. That group has a website, aba.com/regreform, and a 12-point critique of Dodd-Frank that emphasizes its potential effect on community banks, even though advocates of the law say smaller banks are in many instances exempt.

Still, there’s reason to be worried, says Elana Loutskina, an assistant professor of business administration at the University of Virginia’s Darden School of Business. “It’s going to be a very costly regulation for banks,” she says. “I’m not sure how much it will affect their activity. But just the compliance is going to be a huge cost.”

Federal regulation “can be quite useful,” she says. “But Dodd-Frank is a regulation that was written quickly, and we have yet to see whether it has more benefit than it would cost.” The same was true, she says, with the Sarbanes-Oxley Act of 2002, which set new accounting standards for public companies.

Loutskina says even if appropriate regulations are in place, it’s still a cat-and-mouse game. “There are lots of ways to interpret the regulations” defining what trades the banks might engage in, she says. And, it’s a game nobody will really win. “It’s going to be extremely hard for regulators to catch them in the act. But hiding those activities is going to be very costly.”

And, there’s a potential that it could hurt financing for small borrowers, too, she says. “It essentially creates disincentives for mortgage brokers to work with borrowers who want to.” Dodd-Frank could reduce the commission brokers would earn on a mortgage loan, making them less interested in smaller loans. “It wouldn’t be worth their time. So this regulation would kind of backfire for small-loan-size borrowers,” she says.

To a degree, the $5.8 billion loss that JPMorgan blames on internal mismanagement will have a chilling effect all its own. According to the statement Dimon read to the Senate Banking Committee, the losses were triggered when Ina Drew, the company’s chief investment officer, launched a complex strategy of investments “that morphed into something that, rather than protecting the firm, created new and potentially larger risks.” Drew resigned in mid-May.

Loutskina says that’s a message that resonates. “Now everyone has to be much more cautious [at] any Wall Street firm,” Loutskina says. “And there will be much more responsibility asked for from the Wall Street executives.”

The frustrating thing about writing complex financial regulations is the difficulty of knowing what impact they’ll have. There are always unintended consequences, she says. “That’s just how it always works in a fast-growing economy. You have to come up with regulation for a behavior that you haven’t seen before … we just have to remember that every dollar that Wall Street spends on any type of compliance on any kind of paperwork, someone pays that dollar.”

Few industries bring more money to a lobbying effort than the banking and investment sectors, so it’s a sure bet that the lobbying will continue, for years. “We are sure that it brings a whole lot of cost of compliance to the banking industry that ultimately gets passed on to consumers,” Whitehurst says. “If that’s not what’s intended, then let’s take a breath here.”


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