www.lexisnexis.ca Vol. 31, No. 1 January 2015
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Heat rising as Volcker rule looms Print This Article
By Jeff Buckstein

April 2012 issue

A controversial section in the so-called Volcker rule has sparked a backlash from leading finance powers in Canada and the United States just months before it is to take effect in July.

"We understand U.S. efforts to ensure the safety and soundness of the U.S. financial markets, but we have serious concerns that the Volcker rule, as currently drafted, will have significant unintended consequences on Canadian capital markets and investors," said Canadian Bankers Association (CBA) spokeswoman Maura Drew-Lytle.

"The Volcker rule would result in substantial negative impacts on the liquidity of Canadian government and corporate securities, the business model of the Canadian fund industry, the competitiveness and efficiency of Canadian financial institutions and financial markets, and the ability of Canadian regulators to supervise the Canadian financial markets and Canadian banking entities on a worldwide consolidated basis," she said.

Many jurisdictions, including Britain, the European Commission and Japan, have raised similar concerns with U.S. authorities over the Dodd-Frank Wall Street Reform and Consumer Protection Act, she added.

Otherwise known as the Volcker rule for its proponent, former U.S. Federal Reserve Board chairman Paul Volcker, the act places limits on the proprietary trading activities of depository institutions, including banks and non-banks. Restrictions are also placed on certain activities involving hedge funds and private equity funds. U.S. government securities, but not those of foreign governments, are exempted from this provision.

There are also exemptions for proprietary trading activity that is conducted "solely outside of the United States."

The 84-year-old Volcker has vigorously defended his proposed legislation, alluding to financial failures and bailouts following the 2008 economic crisis. In a written submission for the February comment deadline, he reiterated his belief that "proprietary trading of financial instruments — essentially speculative in nature — engaged in primarily for the benefit of limited groups of highly-paid employees and of stockholders does not justify the taxpayer subsidy implicit in routine access to Federal Reserve credit, deposit insurance or emergency support."

Volcker added: "Commercial bank proprietary trading is thus at odds with the basic objectives of financial reforms: to reduce excessive risk, to reinforce prudential supervision, and to assure the continuity of essential services."

Bank of Canada governor Mark Carney was among those vocal in his opposition to the Volcker rule as presently constituted.

In a public letter to Ben Bernanke, chair of the U.S. Federal Reserve Board, Carney wrote that, while he supports the act’s objective to protect taxpayers and consumers and enhance financial stability, "the proposed rule appears to extend well beyond U.S.-insured depository institutions and imposes significant restrictions on Canadian banking entities by limiting their use of U.S.-based resources, personnel and market infrastructure and by preventing them from trading with U.S. counterparties."

Carney added that "these restrictions may have important adverse consequences for Canada, limiting the liquidity of Canadian markets and hence the resilience of the Canadian financial system. Indeed, the proposed rule may undermine, rather than support, progress toward creating a safer, more resilient and more efficient global financial system."

Finance professor David Stowell expressed similar concerns. "When someone doesn’t have liquidity, they get more desperate, and the more desperate they get, the more discount they’re willing to suffer in the sale of their security. That causes security prices to decline and would exacerbate [a] global financial crisis in the future," said Stowell, of the Kellogg School of Management at Northwestern University in Evanston, Ill.

Volcker has also defended the act in regards to those liquidity concerns.

"At some point, great liquidity, or the perception of it, may itself encourage more speculative trading, even in longer-term investments," he said. "Presumably, conservative institutional investors are tempted to turn over positions much more rapidly, at the expense of careful analysis of basic values."

In his submission, Carney said that market making and risk-management activities by Canadian banks may be limited by the exemptions for activity conducted exclusively outside of the U.S.

"As currently written, the exemptions are narrow and may prevent a great deal of trading activity that supports financial stability and efficiency in Canada," Carney wrote. "The compliance regime for identifying permitted trading activities also places a significant burden on Canadian banks."

Carney also worried that trading in Canadian government bonds may be impaired, thus restricting competition and liquidity in those markets. He noted the U.S. Financial Stability Oversight Council justified excluding U.S. government securities from restrictions on proprietary trading in the Volcker rule by stating that banks provide a critical source of liquidity in those markets. The same reasoning, and therefore exemption, should be applied to government securities from other jurisdictions including Canada, Carney wrote.

Although the act contains a number of exemptions to its prohibition on proprietary trading, and sponsorship or ownership in private equity funds and hedge funds, the way the rule is drafted would render these exemptions either unworkable or only operating to the benefit of U.S. institutions, the CBA’s Drew-Lytle said.

For example, although there is an exemption covering activities such as trading or fund sponsorship/ownership entirely outside of the U.S., she said this definition is too narrow to be relied upon by affected Canadian banks — moreover, certain exemptions are for the benefit of U.S. securities only. For instance, debt securities of the U.S. federal, state, and municipal governments are covered, but there is no similar provision for Canadian government securities. Similarly, U.S. mutual funds are covered, but not Canadian mutual funds, said Drew-Lytle.

A practical application of that rule is that "Canadian financial institutions would not be able to serve their ‘snowbird’ customers when they are in the U.S.," she said. Consequently, "we are asking U.S. authorities to exempt Canadian capital markets from the reach of the Volcker rule by expanding the definition of "solely outside of the U.S." and exempting Canadian mutual funds and Canadian government debt."

The Securities Industry and Financial Markets Association (SIFMA) in the U.S. took a similar position.

"Non-U.S. sovereign debt has not been exempted under the Volcker rule, either in the original statute or in the implementing regulations. Our advocacy position is they should be included to the same extent that U.S. treasuries are," said Rob Toomey, SIFMA’s managing director and associate general counsel.

In a news release outlining their concerns about the Volcker rule, SIFMA stated that "the financial stability of many countries is interlinked with that of the United States. Decreased liquidity in foreign sovereign debt will increase risk to the U.S. markets. Additionally, giving preferential treatment to U.S. sovereign debt may encourage other countries to respond with similar nationalist measures."

The American Bankers Association (ABA) has also voiced concerns about the Volcker rule.

"The banking industry fears the oversized nature and complexity of this proposed rule will make it unworkable and will further inhibit U.S. banks’ ability to serve customers and compete internationally," ABA president and chief executive officer Frank Keating said in a statement.

In a letter to U.S. financial regulators, Keating said the Volcker rule provides no basis for clear, comprehensive rule-making. He noted that the activities the act seeks to curtail are too broadly embedded in the traditional business of banking, leaving regulatory agencies with the difficult task of unravelling prohibited from permissible trading and investment activity.

Volcker acknowledged that enforcement will be complex and challenging. But "in approaching this problem, let us not lose sight of the fact that existing risk management practices of large financial institutions here and abroad, including some major U.S. commercial banks, fundamentally failed, at great cost to financial stability and the world economy," he said.

In addition to the Securities and Exchange Commission, various U.S. regulators are in favour, including the Federal Reserve Board, which oversees state chartered banks and trust companies in the Federal Reserve system; Federal Deposit Insurance Corp., regulator of state-chartered banks outside of the Federal Reserve system; Office of the Comptroller of the Currency, which regulates national banks; and the Commodity Futures Trading Commission, regulator of U.S. commodity futures and options markets.

Several of these agencies were contacted by The Bottom Line, but indicated they could not comment to the press at this time.

The Federal Deposit Insurance Corporation will not comment until its board of directors votes on the final rule, said spokesman Greg Hernandez in Washington.

"The agencies will consider the comments. I don’t think it is set in stone. I think a number of the concerns are significant and at a minimum, we expect some changes," SIFMA’s Toomey said.

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