The Volcker Rule, Then and Now

Paul Volcker has long been regarded as a giant in the financial services industry, and with good reason. He was likely most influential during his tenure as Chairman of the Federal Reserve during both the Carter and Reagan administrations, when he played a leading role in bringing down the rampant levels of inflation at the time. A generation later, he returned to the spotlight as chair of the Economic Recovery Advisory Board, a post he retained until early in 2011. His storied history also includes stints with the New York Fed and the Treasury Department, along with senior posts in the private sector at institutions such as what was then Chase Manhattan and investment banking firm Wolfensohn & Co.

In 2014, his name will probably be in the headlines again quite a bit, even if he personally doesn’t say much. That’s because right before Christmas, the American Bankers Association (ABA) announced plans to file a lawsuit challenging key portions of what is generally known as the Volcker Rule, a set of regulations that prevents many banks from speculatively trading with their deposits.

There are many interesting aspects to this developing imbroglio, not the least of which is that the ABA is leading the fight on behalf of smaller institutions, which it says are already concerned over possible repercussions. The harm to these vulnerable companies is described as “real, imminent, and irreparable.”

Of course, no one expects the challenge to end there. Some of the issues covered by the Volcker Rule, such as collateralized debt obligations (CDOs)—which are widely blamed for helping stoke the financial crisis of the last decade—are deeply embedded in the business practices of much larger corporations. If the new rules are not amended, it’s easy to see how many of these Fortune 100 conglomerates might throw themselves into the legal fray.

For the record, it’s far from clear exactly how these regulations will affect the industry, and it’s a matter of interpretation whether the Volcker Rule even prohibits banks from holding CDOs. However, many observers insist that it does exactly that, and some auditors are saying that without further guidance from the Fed (along with the FDIC and the Office of the Comptroller of the Currency, both of which are also named in the potential lawsuit), banks would be well advised write down CDOs, even if it means taking a hit to the balance sheet.

The regulations and potential lawsuits, while new, are in no way a surprise. There’s been intense lobbying behind the scenes for a long time now, but it was only in December that five federal agencies approved the final rule. That’s still left plenty of room for loopholes, hence the ongoing concerns and legal challenges. Besides, banks still have a solid six months to drop the questionable assets from their portfolios, and can subsequently apply for an extension. In other words, these are early skirmishes that help set the stage for more sustained assaults.

There’s also a broader question here that deserves attention. To many, Volcker represents a different breed of financial services veteran, a point he demonstrated during his appearance before a British parliamentary commission a year ago. “The economic and social value of much of the trading and innovative financial engineering is questionable,” he stated forcefully, adding that without regulation banks will inevitably intertwine trades for their own accounts with their retail businesses—a toxic brew by any definition. In this and other appearances, Mr. Volcker has voiced criticism of new financial instruments that disrupted long-held industry processes and practices.

As we noted on this blog at the time, those are exactly the characteristics that sustain and nourish the technology industry. Is there are way for the disruptive innovation of the tech world to be balanced with the stability required in financial services? As these legal challenges play out, we might get some interesting answers to that question.

Fast Facts: Current Economic Conditions in the United States

The Financial Services Roundtable recently released another iteration of its Fast Facts, reliable, bullet-point research about issues facing the financial services industry. Topics span TARP, Dodd-Frank, insurance, lending, retirement savings and more. This iteration focuses on the current economic conditions in the United States.

The United States has enjoyed more than three years of modest uninterrupted economic growth since the end of the recession, with a promising improvement to select industries, including the housing market.


FACT: The US economy sped up in the first quarter of this year, with a growth rate of 2.5%. Despite growth, the Federal Reserve Bank has changed its 2013 GDP projection to an expansion rate in the range of 2.3% to 2.8%.

  • In December 2012, the Federal Reserve projected growth as high as 3.0%.
  • Consumer spending, exports, residential investment, and business spending on equipment and software rose, but it is unclear whether the trend will continue.
  • The Federal Reserve is also concerned that prices of consumer goods have only increased 1.3% year over year, instead of targeted inflation rate of 2% to reflect healthy rises in wages and employment.

FACT: According to nearly 30 investment strategists and money managers surveyed by CNNMoney, stocks will climb further, and the S&P 500 should deliver a healthy 11% return for the year.

  • Last week, the Dow Jones and the S&P 500 witnessed their worst drops since November due to discouraging international and national economic reports.
  • The declines in major stock indices came after dismal growth reports from China, reporting a growth rate of 7.7%, 0.2 percent lower than expected. The reports triggered a massive sell-off in commodities and equity.

FACT: Home prices rose by more than 7% last year, according to the S&P/Case-Shiller index.

  • The number of underwater borrowers, those whose mortgages exceed the value of their homes, fell by almost 4 million last year. While this is an improvement, 7 million borrowers, or one in five, are still underwater.
  • Headwinds from the current round of government spending cuts and tax increases could slow the housing market’s recovery.

FACT: The US unemployment rate fell 0.6 percentage points between March 2012 and March 2013, from 8.2% to 7.6%, but much of the decline from peak unemployment has occurred because of workers leaving the labor force.

  • Job growth slowed sharply in March, with employers adding only 88,000 jobs, much lower than the average monthly gain of 220,000 from November through February, although prior months were revised higher.
  • Health care, construction, and food services were among the top industries for job growth.
  • The monthly average number of Americans seeking unemployment benefits has declined steadily, if modestly, since November and in mid-April was at the lowest level since February 2008.

FACT: While others are slowly returning to work, the unemployment rate for Americans ages 16-24 stands at 16.2%. Additionally, the unemployment rate remains at an elevated 11.1% for those aged 25 and above with less than a high school diploma.

You can view all previous Fast Facts at www.RoundtableResearch.org.

Copyright © 2013 The Financial Services Roundtable, All rights reserved.

 

Stability, Meet Innovation

Think financial services and technology—the two industries have so much to do with each other, yet in some ways they couldn’t be further apart.

To see that strange level of symbiosis, you need look no further that the testimony offered by Paul Volcker, former chairman of the U.S. Federal Reserve, to a British parliamentary commission recently. In sum, Mr. Volcker is distinctly unimpressed by much of the “innovative financial engineering” found in capital markets these days. He believes that unless things change, financial institutions will commingle their accounts with the retail side of the business, and that will cause broad-scale problems.

Long lionized as an elder statesman of the industry, the former Fed chairman is widely credited with holding down inflation during his long tenure, and in that time earned praise (and some criticism for his regulatory stance) from both sides of the political aisle. Even in his ’80s, he led what was then called the Economic Recovery Advisory Board (now known as the President’s Council on Jobs and Competitiveness). Most famously, he is the force behind the Volcker Rule, a section of broader regulation that restricts U.S. banks from making certain investments that don’t benefit their customers.

So why is someone so visionary opposed to “innovative financial engineering?” This is perhaps where the chasm between technology and financial services is widest.

Think about it: Every corner of the technology industry thrives on innovation, and it is always understood that there’s a price tag attached. The new inevitably replaces the old, whether it’s a smartphone upgrade or an entire platform shift. In fact, ‘old’ is a relative term, since there’s always a next big thing or a new/new thing just around the corner. And we all want it that way; this is an industry where ‘disruptive’ technologies get complimented and bankrolled.

It’s not that the issue of regulation doesn’t come up occasionally—the government has certainly kept Microsoft’s lawyers busy for a long time with antitrust concerns, among other examples—but by and large new companies emerge by dint of merit and proudly take on a leadership position. That’s how it was with Microsoft, Google, Facebook, Apple and many others. Even the industry’s brightest minds have no idea what the next name in that pantheon will be; but you can bet that whatever technologies it offers will be not just innovative but disruptive. They’ll prompt (even force) everyone else to change, and that’s a good thing.

The one constant in all this change is that somehow, while the new gadgets and capabilities are always better and faster, they’re also cheaper. New companies and new technologies—all innovative, many disruptive—emerging on a regular basis, radically enhancing the entire landscape while cutting costs: How many other industries can we say that about? Financial services?

Well, these upstart start-ups couldn’t exist without financing, as the fine folks on Sand Hill Road in Menlo Park, the Flatiron district in New York and other hubs of venture capital can attest. There’s also tremendous risk involved; for every one Facebook that generates billions and changes the world, there are many that go nowhere. But still, the stark difference is the way the two industries operate (and are judged)—innovation and disruption is great in one and perilous in the other.

While there’s plenty of action at lower levels, most of the names at the top of the financial services industry pyramid have remained unchanged for decades. The only changes come when some conglomerate merge, or venerable companies go under through too many bad investments. For the most part, what we see now is what we’ve seen for a long time.

Mr. Volcker surely has a point about innovative financial engineering gone bad, but are there alternatives? Will stability in the financial services industry always mean essentially the same set of companies making cautious moves, while the technology side exercises rampant creativity to shift the paradigm regularly? Or can each industry learn more from each other?

 

What do you think? Let us know by tweeting at @bankingdotcom or posting in the comments below.