Consumer advocates are very concerned that last week’s release of an Office of Financial Research (OFR) preliminary working paper, ‘The Effects of the Volcker Rule on Corporate Bond Trading: Evidence from the Underwriting Exemption’ will be used by Volcker Rule opponents to dismantle this important post-financial crisis rule which bans banks’ proprietary trading. Former Federal Reserve Chairman Paul Volcker proposed that banks be prohibited from speculating with their profits in order that their risky securities and derivatives transactions not endanger depositors and taxpayers. The Volcker Rule is part of Title VI of the Wall Street Reform and Consumer Protection Act, which was signed into law in July 2010. Big banks in the United States have been implementing the Volcker Rule for almost five years now, while thousands of others started implementing it in 2015.
The paper’s authors, Meraj Allahrakha, Jill Cetina, Benjamin Munyan, and Sumudu Watugala focused only on one of the Volcker Rule’s four exemptions, the underwriting exemption's effect on corporate bonds in order “to isolate the Volcker rule’s effects separate from other post-crisis changes in bank regulation and broader trends in market liquidity.” The paper did not cover equities, securitizations, derivatives, hedge funds, or private equity, which are all also part of the Volcker Rule.
In their initial findings, the authors found
- “no evidence of the rule’s intended reduction in the riskiness of covered firms’ trading in corporate bonds,
- significant adverse liquidity effects on covered firms’ corporate bond trading with 20-45 basis points higher costs for customers even for roundtrip trades of shorter duration. These effects do not appear to be transitional,
- that the Volcker rule appears to have increased the cost of the liquidity provided by covered firms and has not decreased the liquidity risk exposure of covered firms, and
- that “the Volcker rule has decreased the market share of covered firms. Customers appear to be trading more with non-bank dealers, who are exempt from the Volcker rule but also lack access to emergency liquidity support at the Fed’s discount window.”
It is important to note that working paper’s authors themselves state that the preliminary research findings are in a format intended to generate discussion and critical comments. “Papers in the OFR Working Paper Series are works in progress and subject to revision.” Moreover, the “views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the OFR or U.S. Department of the Treasury.”
While these findings may be preliminary, regulators and legislators should look into them further. I am particularly concerned that the authors found that banks’ risks due to corporate bond trading have not decreased. A significant objective of the Volcker Rule is indeed to reduce banks’ risk from their bond and derivatives trading. Given macroeconomic data showing that the U.S. economy is slowing down and given how leveraged zombie companies are, bank regulators should require banks to disclose more what corporate bond exposures they have and how they intend to mitigate their corporate bond risks. For almost a decade, I have been recommending to bank and financial regulators that they should require that systemically important banks publicly disclose the seven quantitative metrics that they calculate for every securities and trading desk on a monthly basis as required by the Volcker Rule. Disclosure would help market participants determine whether banks are complying with the Volcker Rule. This is important since non-compliance can be expensive, as Deutsche Bank found out the hard way in 2017. Disclosure of the metrics would also enable the public to see what type of securities inventories banks have, how risky banks’ trading books are, and whether they are effectively managing risks that could endanger depositors.
The working paper’s authors found that the Volcker Rule might be increasing banks costs of trading. When this paper is peer reviewed, perhaps we will find that the costs have indeed gone up. Yet given that banks have had numerous record-breaking profitable quarters in the last few years, clearly those increased trading costs have not adversely impacted the banks profits in the least.
In a press release, Marcus Stanley, Americans for Financial Reform Policy Director, stated that this working paper does not contradict previous comprehensive studies which found that "liquidity in the corporate bond market has been robust and has shown no signs of deterioration over the period in which the Volcker Rule was implemented." Specifically he was referring to New York Federal Reserve and Securities and Exchange Commission research. Their research found that "overall corporate bond market liquidity remained strong during the period of Volcker Rule implementation, and in some ways improved over this period." According to Stanley, "This is consistent with a boom in corporate bond issuance and record low spreads during the years in which regulatory reforms were implemented."
Moreover, it is important to remember that before the crisis there was too much liquidity of traded assets, because Basel II, international capital regulatory standards for internationally active banks were not very demanding. Hence, numerous banks globally could buy bonds and stocks without having robust market risk measurement requirements to fully calculate the interest rate, equity, market liquidity, or counterparty risk of these securities. Worse yet, in the U.S., our banks were not even under the Basel II standards, since US rules did not get finalized until l November 2007; hence U.S. banks were under the Basel I standards, which only required capital for credit risks and were designed back in the 1980s before banks and markets were as large and complex as in the years right before the crisis.
The working paper's authors found evidence that banks affected by the Volcker Rule charge significantly lower markups for newly issued bonds they underwrite (that are exempt from most Volcker Rule restrictions on proprietary trading) than they do for other types of bond trades covered by the Volcker Rule. "This is suggestive of some price impact," said Stanley. Yet "the paper does not analyze what, if any, implications this has for the bond market as a whole. The authors themselves state that their data suggests “in aggregate limited impact on all dealers’ corporate bond markups after the Volcker rule’s effective date.”
According to Better Markets President and Chief Executive Officer Dennis Kelleher, “The OFR was a critical innovation of Dodd-Frank to enable independent, deep-dive, data-driven research and analysis so that our front-line regulators would never again be surprised by financial industry activities and risks, which happened repeatedly during the 2008 crash.” However, he is concerned that “Unfortunately, the Trump administration appears to be now putting OFR in the service of Wall Street’s too-big-to-fail banks. It’s preliminary staff “working paper” echoes Wall Street’s demands to gut the Volcker Rule ban on high-risk, dangerous proprietary trading. This was conveniently released on the eve of Trump’s financial regulators expected finalization of a rule gutting that ban.”
Bartlett Naylor, Financial Policy Advocate, at Public Citizen passionately stated that “An industry that gambles with taxpayer-backed deposits will undoubtedly soon hire some of those on layover OFR, who no doubt have their resumes circulating on Wall Street with this faux study beneath their cover letter.”
According to Kelleher “Wall Street complains nonstop about the supposed harm Dodd- Frank causes to their businesses when what they are really crying about is wanting to take bigger risks so they can get bigger bonuses, consequences for others be damned.” Kelleher is concerned that “this is what the fight about the Volcker Rule is really about. The ‘working paper’ is just another way for the Trump administration to support Wall Street, undermine financial reform, and externalize risks to taxpayers.”
