Crapo Bill Only a Drop in Bucket for Deregulation

regulation-8-29-18.pngThe bipartisan “regulatory relief” bill that was adopted by Congress and signed by President Donald Trump earlier this year is a positive development for the banking industry, and it continues a string of good news for banking (and, by extension, the economy at large) since the passage of the Dodd-Frank Act. Banking is highly regulated, and it should be, because most banks’ balance sheets are funded with federally insured deposits to the tune of 90 percent.

The Economic Growth, Regulatory Relief and Consumer Protection Act is not all that the industry had hoped for in a regulatory relief bill, but it is not a complete giveaway to the big banks as some suggested. For the really big banks in this country, the bill does not change much at all.

One of the best things about the legislation is the House and Senate came together to pass a bill that makes sense. On the other hand, the bill seems to further engrain buckets of banks based on asset sizes that have no meaningful support. So, we should get used to the notion that a bank with assets over $10 billion is somehow a “large” bank and that banks with over $250 billion in assets are “systemically important.”

At a high level, the substantive provisions of the new law are relatively brief, when compared to the expanse of Dodd-Frank. Arguably, the mortgage-related provisions of Dodd-Frank did more harm than good because plenty of smaller lenders got out of the housing finance business rather than risk the penalties of noncompliance.

The recent legislation provides that banks with assets of $10 billion or less can avoid some of the more cumbersome qualified mortgage rules under Dodd-Frank, provided that the loans are originated by the bank and kept in the bank’s loan portfolio. Banks that made fewer than 500 mortgage loans in each of the last two years will be exempt from Dodd-Frank’s expanded reporting under the Home Mortgage Disclosure Act as long as the bank has a satisfactory or better Community Reinvestment Act rating.

The new legislation also directs the federal banking agencies to adopt a “Community Bank Leverage Ratio” that will exempt most banks with assets of less than $10 billion from the risk-based capital rules of Basel III. This safe harbor capital requirement is to be not less than 8 percent and not more than 10 percent, and it is going to require an interagency rule-making process, which can take many months to accomplish. So don’t throw away your Basel III models just yet. Most of these so-called small banks will also be exempt from the Volcker Rule, but that too is going to require promulgating rules. It is just going to take time for to reach consensus on what the regulations should say.

A couple of provisions of the new law beneficial to smaller banking organizations should be implemented fairly quickly and without much controversy. The threshold for a “small” bank holding company for purposes of the Fed’s policy statement on the capital and leverage requirements for such entities has been raised from $1 billion to $3 billion. This means bank holding companies with less than $3 billion of total assets will not be subject to capital requirements on a consolidated basis, and allows those holding companies to borrow money at the holding company level and inject it into their subsidiary banks as equity capital. In addition, the exam cycle for well-managed and well-capitalized banks with assets of $3 billion or less has been extended to 18 months. These two provisions could amount to meaningful relief for the banking organizations that can avail themselves of the flexibility afforded by the new law.

For those of us who appreciate the important role that a properly functioning banking system plays in the U.S., our elected officials deserve credit for making changes to Dodd-Frank. But we should not lose sight of the fact that the new law is merely a drop in the bucket of work to be done around bank regulation in the U.S.

Trump’s Big Chance to Remake Banking’s Regulatory Leadership

regulation-7-28-17.pngWhile the prospects for Congressional passage of a financial deregulation bill in 2017 are uncertain, that doesn’t mean bankers can’t look forward to a possible future loosening of the regulatory restrictions they’ve operated under since passage seven years ago of the Dodd-Frank Act.

On June 8, the Republican-controlled House of Representatives passed on a near party-line vote the Financial Choice Act, sponsored by Jeb Hensarling, R-Texas, chairman of the House Financial Services Committee. The measure would repeal several key components of Dodd-Frank including restrictions against proprietary trading (known as the Volcker Act), while also drastically altering the structure and authority of the Consumer Financial Protection Agency (CFPB).

But the Financial Choice Act faces much tougher sledding in the Senate, which the Republicans control by just two seats. There, any financial deregulation bill would need 60 votes to pass and many Senate Democrats have voiced strong opposition to any significant unwinding of Dodd-Frank, which was enacted by a Democratic-controlled Congress following the financial crisis. Brian Gardner, a managing director and Washington research analyst at Keefe Bruyette & Woods, expects any relief measure coming out of the Senate to be modest in comparison to the House measure. “I don’t think there will be a bill on the president’s desk this year,” he adds.

But does that mean bankers can’t expect any regulatory relief in Washington where Republicans control both houses of Congress and the White House? Not necessarily, because the Trump Administration has the opportunity to appoint new—and perhaps friendlier—leadership at several key bank regulatory agencies.

The administration has already nominated former banker Joseph Otting to head up the Office of the Comptroller of the Currency, which supervises nationally chartered banks. Otting would replace former Comptroller Thomas Curry, an Obama Administration appointee whose five-year term expired earlier this year. Otting, who was chief executive officer at OneWest Bank from 2010 to 2015, might be expected to take a more sympathetic view of the regulatory burden that banks operate in—much of it related to Dodd-Frank. Curry, by contrast, was a career regulator who had never run a bank.

The Trump Administration also has the opportunity to appoint an entirely new slate of directors to the Federal Deposit Insurance Corp.’s five-member board over the next year and a half, including a replacement for Chairman Martin Gruenberg, whose five-year term as chairman expires in November. President Trump nominated former congressional staffer James Clinger to replace Gruenberg, but Clinger has since withdrawn his name from consideration, citing family concerns. Gruenberg was a Senate staffer and trade association president before coming to the FDIC.

The FDIC board consists of three independent directors appointed by the president, as well as the comptroller of the currency and director of the CFPB. Richard Cordray’s five-year term as CFPB director runs through July 2018. A piñata for Republican criticism in Washington almost from the day he took the job, Cordray most certainly will not be reappointed by Trump, and it has been reported that he may run for governor in his home state of Ohio next year.

There are also three open seats on the Fed’s seven-member board of governors, including someone to serve as the Fed’s point person on financial regulation. Former Fed Governor Daniel Tarullo had played that role during the Obama Administration, and was known for taking a tough regulatory stance on the country’s largest banks, stepped down from the board in April. His place would be taken by Randal Quarles, a former Treasury department official under George Bush who has been nominated to serve as vice chairman for supervision. Quarles said in his prepared remarks before the Senate Banking Committee this week that post-crisis bank rules need some “refinements.”

But the most important regulatory position of all belongs to Fed Chair Janet Yellen, whose term ends in February 2018. Not only is the Fed considered to be first among equals of the regulatory agencies, but Yellen also controls the agenda at the Fed—including what gets talked about at meetings, Gardner says. Yellen was an Obama appointee and has largely been supportive of the past administration’s regulatory philosophy. Gardner says that historically most Fed chairs get two terms, although Trump has been noncommittal about reappointing Yellen. While it would be unusual for Yellen not to be reappointed, Trump has shown that he’s not a slave to convention. Asked what he thinks the president will do, Gardner, laughing, says “I have absolutely no idea.”

What Are the Prospects for Regulatory Reform?

regulation-6-7-17.pngEditor’s note: The House passed the CHOICE Act Thursday 233-186 but it isn’t expected to earn enough votes in the Senate to become law.

Financial regulatory reform is a priority for President Donald Trump and his administration, which views burdensome and costly regulation as a significant impediment to lending and economic growth. However, more than 100 days into the Trump presidency, neither the president nor Congress has taken meaningful action on financial regulatory reform. While it is impossible to predict what the administration’s legacy will ultimately be on regulatory reform, its actions thus far with respect to regulation generally, proposals introduced in Congress by Republicans, and the president’s power to appoint agency officials may offer some clues of what’s to come.

Financial CHOICE Act
The Financial CHOICE Act, which House Financial Services Committee Chairman Jeb Hensarling, R-Texas, has called a blueprint for financial regulatory reform, passed the House Financial Services Committee on a party line vote on May 4. The current version of the CHOICE Act would, among other things:

  • Transform the Consumer Financial Protection Bureau (CFPB) from an independent agency to an executive agency, subject to Congressional oversight and the Congressional appropriations process, with its director removable at will by the president.
  • Make the CFPB an enforcement agency without a bank supervisory function.
  • Eliminate the CFPB’s authority to enforce unfair, deceptive or abusive acts and practices.
  • Provide regulatory relief to community banks and those engaged in residential mortgage lending.
  • Repeal the Volcker rule, which prohibits banks from proprietary trading.
  • Provide regulatory relief for banks that maintain a 10 percent leverage ratio.
  • Overturn the U.S. Second Circuit Court of Appeals’ decision in Madden v. Midland Funding.

While the CHOICE Act is likely to pass the House in some form, its chances of passage are remote in the Senate since 60 votes are required to overcome a filibuster. Nevertheless, some targeted reforms, including regulatory relief for community-based institutions, could be enacted.

Executive Orders
With material changes to the Dodd-Frank Act likely to die in the Senate, President Trump’s executive orders may form the basis of the administration’s regulatory reform strategy. President Trump has signed six executive orders impacting the financial services industry. Among other things, these executive orders:

  • direct the Treasury secretary to consult with the nine member agencies of the Financial Stability Oversight Committee and draft a report to the president analyzing current laws and regulations for their consistency with the seven so-called core principles of financial regulation;
  • require each agency to repeal two regulations for each new regulation implemented;
  • require a cost/benefit analysis before new regulations are adopted; and
  • require agencies to establish regulatory reform task forces and appoint regulatory reform officers whose job will be to identify burdensome regulations and evaluate their consistency with the core principles.

However, executive orders can accomplish only so much. Just as President Obama could not unilaterally repeal legislation, President Trump will not be able to roll back statutory provisions of Dodd-Frank without acts of Congress. Further, while it may be possible to soften the impact of certain Dodd-Frank regulations, the Administrative Procedures Act generally requires that any regulations implemented through a notice and comment process go through a similar process before they can be repealed.

President Trump’s broadest impact on financial regulatory policy may come from his appointments to federal agencies. Treasury Secretary Steven Mnuchin has been confirmed. Three vacancies currently exist on the seven-member Federal Reserve Board of Governors. Former Treasury Undersecretary Randy Quarles is expected to be appointed as the first vice-chair of supervision, filling one of these vacancies. When the terms of Chair Janet Yellen and Vice-Chair Stanley Fischer expire in February 2018, the president will have the opportunity to reshape the central bank. Likewise, the comptroller of the currency has been replaced on an acting basis by banking attorney Keith Noreika and may be replaced by former One West CEO Joseph Otting on a permanent basis. If CFPB Director Richard Cordray is removed or leaves of his own accord later this year to run for Governor of Ohio, as many suspect he may, the president would have the ability to appoint a new CFPB director. Further, there is currently a vacancy on the Federal Deposit Insurance Corp. board and current chair Martin Gruenberg’s term as director will end in November. Since the comptroller of the currency and the director of the CFPB also sit on the FDIC’s board, the president soon will have an opportunity to appoint four of the FDIC board’s five members.

While the president can’t order officials at these agencies to take particular actions, and his ability to remove agency officials may be limited, his appointees will likely exercise a more restrained approach to regulation than Obama-era appointees. Over time, we expect a tangible difference in how banking agencies approach supervision and enforcement. At the end of the day, the president’s appointment power may be the most effective tool in his tool box.

Poll: Bankers Sound Off on Election

election-10-19-16.pngA majority of bankers believe that Republican presidential candidate Donald Trump will have a more positive impact on the nation’s economy than Democratic nominee Hillary Clinton if he’s elected to the Oval Office on November 8, although many professional economists disagree. And he’s probably got their vote, too, according to Bank Director’s 2017 Bank M&A Survey, sponsored by Crowe Horwath LLP. However, fewer say they support Trump, compared to bankers who said they’d vote for Mitt Romney in 2012.

  • Fifty-five (55) percent believe that a Trump presidency would be best for the United States economy.
  • Fifty-eight (58) percent plan to vote for Trump, compared to 10 percent for Clinton. Twenty-one percent are unsure which candidate, if any, has their vote.
  • Sixty-six (66) percent believe that Trump is more likely to reduce the industry’s regulatory burden.

More than 200 bank executives and directors participated in the survey. Bank Director’s survey was conducted in September, before the debates took place and allegations of sexual assault surfaced against Trump. During the survey period, Real Clear Politics, which aggregates poll averages across the country, had Clinton polling ahead of Trump by 0.9 to 3.9 percent. The news outlet predicts a Clinton victory at this time.

Economists are not all in agreement about the impact that a Trump presidency would have on the U.S. economy, in part due to his ideas on taxes and trade. Several have predicted a dire outcome if Trump prevails on Election Day. The advisory firm Oxford Economics, based in Oxford, England, predicted in September that the economic policies outlined by Trump could shrink the U.S. economy by $1 trillion by 2021. The rating agency Moody’s Analytics stated in June that a Trump administration will isolate the U.S. economy, incur more government debt and result in the loss of 3.5 million jobs. A month later Moody’s predicted that Clinton’s economic policies would “result in a somewhat stronger U.S. economy.”

In contrast, David Woo, head of global interest rates and currencies research at Bank of America, told Bloomberg in September that in a Trump presidency “the U.S. economy would probably take off in a big way,” due to the candidate’s proposed fiscal policies, including extensive spending on infrastructure and tax cuts.

Richard Hunt of the Consumer Bankers Association says bankers don’t put a lot of faith in these sorts of wonkish pronouncements. Bankers see an experienced CEO in Trump, not a career-long politician like Clinton. “[Clinton would be] a continuation of [President] Obama’s policies, and a lot of bankers are frustrated,” says Hunt. The CBA doesn’t endorse a specific candidate for the nation’s top office.

Trump’s statements indicate a consistent distaste for regulation. “Dodd-Frank has to be either eliminated or changed greatly,” Trump told CNBC in May 2016. “The regulators are running the banks.”

Clinton plans to defend the Dodd-Frank Act. Her campaign also advocates new reforms for the financial sector, including a so-called “risk fee” for big banks that would scale higher for banks with larger amounts of and riskier forms of debt, compensation rules to curb risky behavior and a strengthened Volcker rule. Breaking up big banks is also on the table.

Bankers aren’t as in love with Trump as with past Republican nominees. In a survey conducted in advance of the 2012 election, Bank Director found that 79 percent supported Mitt Romney, compared to 8 percent for President Obama and 13 percent undecided. Support for Romney was 21 points higher than for Trump. It’s not that Clinton is seeing significantly more support—more bank executives and board members are unsure of whom to support, if anyone, compared to four years ago.

In a recent twist for the industry, this year’s election could be crucial to the future of the Consumer Financial Protection Bureau. On October 11, a federal appeals court found the bureau’s structure to be unconstitutional, and ruled that its directorship should fall under the control of the president, a decision that could be appealed by the Obama administration. If that decision isn’t overturned, it’s likely that a Clinton presidency would strengthen the agency. A Trump administration is likely to weaken the CFPB.

“It has to be Trump,” says Blair Hillyer, the chief executive officer at First National Bank of Dennison, a $221 million asset community bank in Dennison, Ohio. He’s a lifetime Republican that isn’t thrilled with either candidate, but he believes that Dodd-Frank has been too damaging to the industry. Under Hillary Clinton, “the regulation would continue, and we’ll continue to lose community banks,” he says.

The complete results of the 2017 Bank M&A Survey will be available on in November.

Waiting for Volcker

5-2-13_Vockler.pngIt has been nearly a year since the Volcker Rule was supposed to go into effect and there is still no agency rule to implement the Volcker Rule, which was passed as part of the Dodd-Frank Act. Regulators have shown few signals that a final implementing rule should be expected in 2013. 

The statutory provisions referred to as the Volcker Rule contain two main elements: a prohibition on proprietary trading by banking entities, and a prohibition on certain bank investments in private equity and hedge funds. The proprietary trading ban includes a number of exemptions, including for market making and hedging.

The statute itself leaves the interpretation of these terms to five regulatory agencies: the Board of Governors of the Federal Reserve System (Fed), The Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).

In October 2011, the Fed, FDIC, OCC, and SEC jointly proposed implementing regulations.  In February 2012, the CFTC issued a substantially similar proposal. 

Under the Dodd-Frank Act, the five agencies are not required to issue rules jointly. Instead, the statute allows the Fed, FDIC, and OCC to issue joint rules with respect to insured depository institutions (IDIs); the Fed to issue rules for bank holding companies, nonbank systemically important financial institutions, and their subsidiaries; and the SEC and CFTC to issue rules for entities for which they are the primary regulators. 

To their credit, the regulators acted jointly at the proposal stage. But, this statutory construct shows the potential for the Volcker Rule to become a regulatory quagmire. It would hardly be efficient if a bank holding company had to separately comply with one rule by the Fed for the holding company, a second joint rule by the banking regulators for any IDI subsidiaries; and a third and fourth rule by the SEC and CFTC for broker-dealer, swap dealer, futures commission merchant, and other subsidiaries regulated by those entities. Aside from substantive requirements, each rule potentially could have different (maybe contradictory, maybe overlapping) compliance and data reporting requirements.

So it may be a victory alone if the regulators adopt a joint final rule. Rumors have circulated in Washington, D.C., that the agencies are prepared to go their separate ways.

Since the rule was proposed, market participants spent significant resources to comment on the rule. Although there have been calls from the political proponents of stricter rules for the agencies to make the final rule tougher than the proposal, many of the comments described ways in which the proposal could lead to significantly reduced market liquidity, increased costs for consumers and other end-users, and could make certain markets economically unviable.

One of the more difficult issues is how the Volcker Rule should distinguish between prohibited proprietary trading and permitted market making and hedging. The proposed rule uses what has been characterized as a trade-by-trade approach to determine whether a position is proprietary, or allowable under an exemption. Commenters noted that market making inherently involves principal risk, dynamic hedging, and that risk is not managed on a trade-by-trade basis. The proposed approach seems suitable for only the most liquid markets, and likely to create barriers to being an effective (and profitable) market maker in less liquid markets, where positions can be held in inventory for long periods, and hedges are not one-to-one. 

Thus, the question is how can the regulators proceed? There are two approaches they should consider. One, the agencies could use a safe-harbor approach, and identify specific activity that would be permitted under the rule. Of course, the danger with this approach is that the regulators draw the safe harbor too narrowly. Two, the regulators could define market making to include hedging that is done as a part of a market-making business, and could provide that the criteria to be a market maker would be fluid depending on the liquidity and other features of the market in which a firm was operating. The danger here could be a lack of legal certainty for any particular market.

In all events, it is almost certain that the final rule will require years of legal interpretation by private practitioners and the regulators before it works in the real world.

Dodd-Frank Round-Up: Where We Are and What Needs to Be Done

future-signs.jpgIt’s been two years since the Dodd-Frank Act was passed, and regulators have published 8,800 pages of regulations ironing out the details of the law. Many rules still have not been written, leaving huge portions of the Act in limbo. This article takes a look at the status of major pieces of the legislation with an eye towards the impact on commercial banks and the banking system.


About: The recent financial crisis highlighted risks taken by individual companies in a highly interconnected financial sector. Dodd-Frank established a framework for monitoring and regulating this systemic risk. 

Past Developments: The newly created Financial Services Oversight Council released its final rule for designating nonbank systemically important institutions. The top banking firms recently released their “living wills,” or plans to unwind themselves in the event of failure without government or taxpayer assistance. 

Future Developments: The Federal Reserve will finalize capital requirements for large institutions as well as the specific rules for implementation of Basel III, an international agreement that strengthens capital requirements and adds new regulations on bank liquidity and leverage.

—From: Weil, Gotshal & Manges LLP, “The Dodd-Frank Act: Two Years Later,”  For access to their full report, click here.



About:  The Durbin Amendment part of Dodd-Frank, which caps debit card interchange fees for banks above $10 billion in assets, has likely had the greatest immediate impact on the banking industry, as it went into effect in October of last year.

Past Developments:  The impact on banking revenues has been swift. The industry reported a $1.44 billion loss of revenue in the fourth quarter of 2011, resulting in an annualized $5.75 billion loss if this pattern holds, according to Novantas LLC, a New York City-based consulting firm.

Future Developments:  It is still uncertain whether banks under $10 billion in assets will be able to charge more for debit card interchange than bigger banks in the long term, but so far, the smaller banks haven’t reported a loss of income in aggregate.


About: Dodd-Frank requires institutions to show that their incentive arrangements are consistently safe and do not expose their firms to imprudent risk. 

Past Developments: The Securities and Exchange Commission implemented rules last year requiring publicly traded companies to take advisory shareholders votes on executive compensation, also known as “say on pay.” It also implemented rules on the independence of compensation committees and compensation advisors, as well as on “golden parachute” payments to executives.

Future Developments: Dodd-Frank included a provision that instructed agencies to issue guidelines on incentive compensation. Although proposed more than a year ago, they have not been finalized.

—From the Securities and Exchange Commission and Deloitte LLP’s “Dodd-Frank Act Two-Year Anniversary: Seven Takeaways on Dodd-Frank’s Impact on Compensation.”  For access to their full report, click here.


About:  The CFPB is the first federal agency focused solely on consumer financial protection, and it holds responsibilities previously managed by several other regulators.  The CFPB has examination authority over banks, thrifts and credit unions with $10 billion or more in assets, as well as some large nonbank financial service companies that previously escaped federal regulation, such as payday lenders.

Past Developments: With a new director in place, the CFPB has not simply been implementing rules it inherited from other regulators, but promulgating many new, substantive rules. 

Future Developments: Further rulemaking may help illuminate the meaning of “unfair, deceptive and abusive” acts and practices, which the CFPB is tasked with eliminating, especially in the context of mortgage servicing and origination. New mortgage disclosure documents are in the process of being finalized.

—From Weil, Gotshal & Manges LLP,  “The Dodd-Frank Act:Two Years Later.”  For access to their full report, click here.


About: Dodd-Frank amends the residential mortgage portions of several federal housing statutes. Among other things, mortgage originators now owe a duty of care to borrowers.  

Past Developments: Creditors are now required to make a reasonable and good faith determination that a consumer has a reasonable ability to repay a residential mortgage.

Future Developments: The CFPB is considering rules to implement provisions of Dodd-Frank that would address mortgage loan originator qualifications and compensation. 

—From Morrison & Foerster’s “Dodd-Frank at Two.”  For access to the full report, click here.


About:  The Dodd-Frank Act is designed to provide a comprehensive framework for the regulation of the over-the-counter derivatives market to provide greater transparency and reduce risk between counterparties.

Past Developments: The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have both been missing statutory deadlines.

Future Developments: It is yet to be determined specifically how these provisions will be applied across borders and to what extent they will cover U.S. operations of foreign firms. 

—From Deloitte LLP’s “Dodd-Frank Act Two-Year Anniversary: Five Takeaways on Dodd-Frank’s Impact on Derivatives.”  For access to their full report, click here.


About: The Volcker rule prohibits banks and bank holding companies from engaging in proprietary trading or owning private equity and hedge funds, with some exceptions. It is considered one of the most controversial aspects of Dodd-Frank.

Past Developments: The Fed, FDIC, OCC, and SEC jointly issued the proposed rule, which further defined key terms such as “banking entity,” “proprietary trading,” and “covered fund,” as well as outlining exceptions to the rule’s prohibitions.  If proposed in its present form, many investment products having nothing to do with private equity or hedge funds will be prohibited.

Future Developments: Lawmakers and regulators are pushing for the final rule by the end of the year, but affected financial institutions will have until at least July 21, 2012 to conform to the rule.

—From Weil, Gotshal & Manges LLP, “The Dodd-Frank Act: Two Years Later.”  For access to their full report, click here.


 About: Based on “lessons learned” from the financial crisis, regulators are examining more critically the quality of capital held by U.S. banking organizations as well as credit risks. 

Past Developments: In early June 2012, the U.S. banking agencies published for comment a series of three regulatory capital rulemakings in accordance with the international Basel III agreement, two of which would substantially revise the current regulatory framework. Comments on the proposals are due September 7.

Future Developments: Many of the new capital guidelines and rules haven’t gone into effect and will be gradually phased in over a period of a year or up to a decade, depending on the size of the bank and the rule.

—From Morrison & Foerster’s “Dodd-Frank at Two.”  For access to their full report, click here.

Volcker Rule: Hero or Villain?

With the Dodd-Frank Act’s Volcker rule coming into effect next month and placing limitations on big banks’ trading abilities, we asked bank attorneys across the country what they thought would really come from this change. Although many different possible scenarios were cited, it was almost unanimous that all the attorneys believe the Volcker rule is likely to cause more damage than good. From hurting the efficiency of our markets to heightening other risks and limiting diversification, one must wonder, is the Volcker rule really going to be a good thing for the health of the financial system? 

Will the Volcker rule achieve its intended goal of lowering the risk profile of large banks by prohibiting them from engaging in proprietary trading activities?

Chip-MacDonald.jpgThe Volcker rule is unlikely to achieve its intended goal because it is so difficult to distinguish proprietary trading from hedging and market-making. Banks are already limited by the types of instruments and securities they can trade in for their own account by Section 16 of the Glass-Steagall Act, which remains in effect as Section 24(7) of the National Bank Act. The most likely effect is that systemic risk may increase as market liquidity decreases, as banks and their affiliates maintain smaller securities inventories, consistent with the Volcker rule proposals. This could widen securities’ bid/ask price spreads, and make the markets less efficient. This will also have an adverse effect on smaller financial institutions which depend upon larger banks and their trading desks for their investment securities purchases and sales.

—Chip MacDonald, Jones Day

Douglas-McClintock.jpgRules are destined to be broken. Like so many well-intentioned laws and regulations, the Volcker rule might end up doing exactly the opposite of what is intended—that is, increasing the risk profiles of large banks, through hedging and other transactions with higher risks than old-fashioned proprietary trading activities. Can you identify any proprietary trading investments that have caused losses in the same ballpark as JPMorgan’s recently acknowledged losses or the hedge fund Long-Term Capital Management’s losses back in 1998? These losses illustrate that the financial marketplace can be a tough taskmaster when seemingly well-thought-out investment strategies, by some very smart traders, run into the ever-changing real world marketplace. No one has a lock on what will work best in the future financial marketplace, but savvy, conservative bankers with competent advisors usually do all right in the long-run.

—Doug McClintock, Sara Lenet, Alston & Bird

Heath-Tarbert.jpgI am generally skeptical of the Volcker rule’s purported benefits to bank safety and soundness. I think appropriate capital, leverage, and liquidity requirements—when combined with a robust risk management framework and culture inside each institution—will do far more to lower the risk profile of large banks. Moreover, the Volcker rule in its current form only compounds the problem by requiring regulators and market participants to make, in some cases, spurious distinctions between and among proprietary trading, market making and hedging. 

—Heath Tarbert, Weil, Gotshal & Manges LLP

Gregory-Lyons.jpgCertainly the Volcker rule will restrain bank proprietary activities, and any reduction of activities reduces risk profiles to a degree. However, after a point, protection turns to paralysis. Years after Dodd-Frank, there still has been no evidence that proprietary trading contributed to the financial crisis, and the rules could put U.S. banks at a competitive disadvantage, particularly with respect to their worldwide operations.

 —Greg Lyons, Debevoise & Plimpton

Peter-Weinstock.jpgIt is too early to determine the ultimate scope of the Volcker rule.  Regardless of the ultimate shape of the Volcker rule, the real key is whether financial institutions can set appropriate risk tolerances, monitor adherence and stay within them. The leaders of the bank regulatory agencies recently were questioned by the Senate Banking Committee in the aftermath of the JPMorgan Chase & Co. $2 billion-plus trading losses. The regulators were unanimous that risk neither should be nor could be removed from banking. The focus on hyper- technical rules, such as those promulgated in draft form to enforce the Volcker rule, rather than on risk management principles and practices, is misplaced.

—Peter Weinstock, Hunton & Williams

Mark-Nuccio.jpgBy completely taking away proprietary trading and investment in and sponsorship of private equity, hedge and other similar private funds, the Volcker rule inappropriately concentrates investment and other risk in other activities and asset classes, all of which have run into calamities in the past. For example, subprime lending is not barred by the Volcker rule. We will not be well-served in the long run by having the largest and most sophisticated U.S. financial institutions become one or two-trick ponies. That said, the Volcker rule is upon us and, in the absence of final regulations, we are spending lots of time with clients developing conformance plans with our divining rods.

—Mark Nuccio, Ropes & Gray

What will JPMorgan’s trading goof mean for regulation?

jamie-dimon.jpgMuch has been made of the trading mishap at JPMorgan Chase & Co.’s London office, resulting in current estimates of a $3 billion loss to the company or more. But what is at stake here is not so much JPMorgan’s financial health, which doesn’t appear in question, but future regulation of the financial sector.

JPMorgan CEO Jamie Dimon has been arguing publicly against certain kinds of regulation, including the Volcker rule, which would limit proprietary trading by the big banks.

“I think it’s unnecessary, especially when you add it on top of all the other [regulation],’’ Dimon reiterated this week before a U.S. Senate committee, where he spent two hours explaining his company’s trading mistake.

Welcome to the new age, where big banks will have to answer questions not just from their shareholders and customers, but from Congress as to what went wrong with their business and who knew what, and when.

Critics are using JPMorgan’s trading loss, which occurred in the division that invests customer deposits, to argue the Volcker rule ought to be strict and tough on banks.

Regulators have missed 67 percent of their rulemaking deadlines in implementing the Dodd-Frank Act, according to the Davis Polk law firm. Much remains to be written that will affect companies such as JPMorgan and smaller banks as well.

That’s why the public charades are so interesting.

“In the political world, it’s going to be hard for regulators to embrace a looser process rather than a stricter process,’’ says Harold P. Reichwald, a partner in Los Angeles at the law firm Manatt, Phelps & Phillips. “This incident with JPMorgan will have the effect of creating a heightened sensitivity on the part of regulators to pressure the banks they regulate to have a more formal approach to risk management.”

Michael Klausner, a professor with the Rock Center for Corporate Governance at Stanford University, thinks the JPMorgan trading loss really shouldn’t be a regulatory concern.

“Even if you had a 50 times greater hit to capital, you’d still not have a systemic event,’’ he says. “As a policy matter, what we worry about is a systemic event, or what would have an impact on other banks.”

JPMorgan says its capital levels remain strong and it will be profitable in the second quarter, despite the loss.

Klausner says that you can make the argument that the trading loss is serious enough threaten the CEO’s job and the value of the company’s stock, but as a regulatory matter, “it’s trivial.”

But nowadays, banks such as JPMorgan are addressing their business activities to a much wider audience than shareholders.

Among Dimon’s details about what went wrong with the risk management process at the chief investment office (CIO):

  • CIO’s strategy for reducing the synthetic credit portfolio [e.g. credit default swaps] was poorly conceived and vetted. The strategy was not carefully analyzed or subjected to rigorous stress testing within CIO and was not reviewed outside CIO.
  • In hindsight, CIO’s traders did not have the requisite understanding of the risks they took. When the positions began to experience losses in March and early April, they incorrectly concluded that those losses were the result of anomalous and temporary market movements, and therefore were likely to reverse themselves.
  • Personnel in key control roles in CIO were in transition and risk control functions were generally ineffective in challenging the judgment of CIO’s trading personnel. Risk committee structures and processes in CIO were not as formal or robust as they should have been.
  • CIO, particularly the synthetic credit portfolio, should have gotten more scrutiny from both senior management and the firm-wide risk control function.

Dimon detailed the company’s response to the “incident,” which included replacing much of its top investment management team and chief risk officer for the division. It also included establishing a new risk committee just for the chief investment office.

Sen. Charles Schumer, D-New York, asked Dimon during the hearing why the risk committee of the board missed what was happening in the trading office.

“Some questions have been raised about the oversight of your risk committee,’’ he said. “Why didn’t it do its job?”

Dimon said if management didn’t catch it, then the risk committee couldn’t.  That sounds reasonable, but now the risk committee must find out why it wasn’t learning about the risks that the bank was taking. Dimon said the bank will learn from its mistake. So the question is now: What will regulators make of it?