follow the money

A blog on business law, politics, and white collar crime

March 6, 2014

The Neverending Story

Craving perspective on the state of financial reform generally and the implementation of the Volcker Rule in particular? If so, I recommend “When Regulation Threatens, Bankers Predict Doom for Main Street,” published yesterday on ProPublica by Pulitizer Prize-winning journalist Jesse Eisinger.

Masterfully simplifying the complex, Eisinger provides a view of one of the tactics successfully employed by the financial services industry to remove rules freshly issued under the Dodd-Frank Act. In this piece, Eisinger offers specifics concerning the Volcker Rule implementation. (For backgrounder on the Volcker Rule, see our previous Perpetual Crisis blog post: “Volcker Rule: A Tall Order and a Small Victory“).

Minimal expertise is needed to grasp why this is important:

“Even for those who don’t know a C.L.O. from the Electric Light Orchestra, there is nevertheless a larger point here.Reforming the banking system is a fight that will never end. Banks and their political allies fought financial reform before it was passed. To paraphrase a famous orator: They shall fight it in the courts, they shall fight it with the regulators, they shall fight it in the halls of Congress. They will search ceaselessly vulnerabilities and loopholes. They will sow doubt about the rules. . .Even when they lose, their harassing tactics will have benefits. A distracted Securities and Exchange Commission has failed to complete many important Dodd-Frank rules covering securitization. The agency still has not finalized rules banning conflicts of interests in securitizations to prevent the kind of misrepresentations that banks engaged in with the infamous Abacus and Magnetar transactions.”


December 10, 2013

Volcker Rule: A Tall Order and a Small Victory

Today’s vote to approve the long-awaited Volcker rule marks a small victory in the ongoing battle to end Too Big to Fail (TBTF). Generally speaking, this new rule will restrict banks from gambling with taxpayer-insured deposits, a practice that helped enable the 2008 financial crisis. But the devil is in the details: there are many concerns to resolve before the rule goes into full effect in 2015. And, even if the rule is strengthened, it will not be sufficient. Quite simply, the Volcker rule is just one part of the larger, ongoing reform efforts; it cannot do all of the heavy lifting to restore financial stability and end TBTF.

The five-agency vote to approve this 71-page rule was as follows: The Board of Governors of the Federal Reserve (unanimous); the Federal Deposit Insurance Corporation (unanimous); the Securities and Exchange Commission (3-2); and the Commodity Futures Trading Commission (3-1). The Comptroller of the Currency, who has the authority on behalf of the Office of the Comptroller of the Currency signed the rule today (and also voted for the rule this morning in his capacity as a board member of the FDIC).

Missing from the buzz around today’s vote is a clear explanation of just what problem this rule was designed to address and what problems remain unresolved. Here’s my attempt at clarity:

Big Banks Behaved Badly: Because They Could

To understand what the Volcker Rule is supposed to stop, it is helpful to pretend you are a bank.  If you were a bank, you could use just $3,000 of your own money as equity and go out and borrow up to $97,000 from friends, neighbors and even strangers in the form of deposits, for example. You might use those deposits to make home loans, commercial loans or purchase investments including low-risk or high-risk securities (subject to keeping a small percentage in cash or liquid investments on reserve).

If you were a bank, it would be easy to borrow money with such a thin equity cushion, because your depositors (who are actually loaning you money) would know that they could withdraw their funds at any time. And your depositors would have little care as to what you did with their money, as they would understand that if you went bust they would be made whole­, expecting that the FDIC would pay them back up to $250,000 per account. And, they might also know, if you faced a liquidity crunch or a run where more depositors demanded their money than you had available in liquid investments, you could get low-interest loans from the Fed.

These two safety nets––FDIC insurance and Fed funding­­––helps you and your depositors, but it is not without a cost to the society. The money in the FDIC deposit insurance fund (collected through bank assessments) is a small fraction of the total insured deposits in the U.S. As such, should the deposit insurance fund run dry, before paying off depositors, the government, meaning the taxpayers, might again foot the bill.  The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) and related regulations reduced this likelihood (including by proposing increased equity requirements for banks, providing the Fed with preemptive break-up powers under Section 121, and through the FDIC’s new resolution powers for failed firms under Title II). However, future TBTF-taxpayer-funded-bailouts have not been eliminated.

Now, let us pretend you are even bigger. You are now a bank with $30 billion in equity. You can have up to $970 billion in deposits and other short-term borrowing. At this size, your large creditors are not insured depositors and don’t have the benefit of U.S. government-backed FDIC insurance. However, they are comfortable lending to you, in part because of the implicit TBTF guarantee — the expectation that if you were to fail, the government would (either directly or through the Fed) bail you out. Thus, in the absence of the Volcker rule, you as a bank could take a large portion of that $970 billion and invest in speculative activities at a massive scale. A recent example was the $6 billon “London Whale” trading losses incurred by JPMorgan Chase. These were generated by the JPMC unit that managed a portfolio of more than $300 billion in excess customer deposits, a portion of which was devoted to trading complex synthetic credit derivatives.  The bank said that what began as a hedge against interest rate risks and credit risks became a proprietary bet.

What’s the Volcker Rule?

Today’s final rule implements Section 619 of Dodd-Frank which was drafted and shepherded through the legislative process by Senator Jeff Merkley (D-OR) and Senator Carl Levin (D-MI). Though this provision is sometimes referred to as “Merkley-Levin,” it is more often called the “Volcker rule,” named for former Fed chairman, Paul Volcker who recommended placing restrictions on proprietary trading by banks to President Barack Obama.

Section 619 amends the Bank Holding Company Act to ban covered banking entities (that have access to FDIC insurance and loans from the Fed) from engaging in proprietary trading –– essentially, trading in securities, derivatives, commodity futures and options for their own accounts. Section 619 also limits how much such banking entities can invest in and be involved with hedge funds and private equity funds (known in the rule as “covered funds”).

Section 619 was meant to be similar to the Glass-Steagall Act. Glass-Steagall, enacted in 1933 as part of the New Deal, created a firewall between traditional banking (deposit taking) and investment banking (securities operations). It prevented those banks that benefit from the government safety nets from putting the deposit insurance fund at risk. It allowed investment banks that wanted to speculate to do so but without having their losses backed by the government. But a bank had to choose; it was either a depository institution or a investment banking house, not both.  This law (along with other regulations) helped keep the country safe from major banking failures for half of a century. In contrast, the prohibition in the Volcker rule does not go as far as Glass-Steagall did. Section 619 does not mandate a clear structural change (i.e. requiring financial firms that have depository banks to divest of their securities operations). Instead, it attempts to cut back on the types of securities and other high-risk trading the banks can engage in.

Under the Volcker rule statutory provision (and the implementing rule), some activities are permitted and some are not. Permitted activities include, for example “market making” (such as maintaining an inventory of securities for the purpose of buying and selling securities for customers), underwriting securities offerings, and certain risk-mitigating hedging. In the prohibited category are “proprietary trading” and certain investments and relationships with private pools of capital (such as hedge funds and private equity funds). As a result, the effectiveness of the Volcker rule depends largely upon the strength of internal bank compliance programs to properly draw a line between permitted activities and prohibited. And it depends upon the knowledge and willingness of regulators to enforce the law.

Improvements and Remaining Weaknesses:

Today’s final version of the Volcker rule is an improvement in some aspects from a draft rule issued back in 2011. However, there are some remaining weaknesses. These could undermine the rule’s potency.

November 26, 2013

Yes, another bank scandal . . .wait, don’t yawn

Turns out there’s a word in German for the feeling that could set in five years after the financial crisis of 2008. No, it’s not schadenfreude (more on that soon), but weltschmerz, or world-weariness. The most recent example that triggered this feeling was the report on Monday that the Royal Bank of Scotland “forced business customers to default on loans so that the bank could charge higher fees or seize their properties and sell them.”

At one time this would have triggered outrage, but even for those who notice, this news has to take a number. There are plenty even more outrageous things vying for our attention, and the outrage meter is broken.

We need to resist this kind of seen-it-before-nothing-fazes-us attitude when we learn of yet another bank scandal. Additionally, any sense of schadenfreude, or enjoyment in the misery of others is equally unhelpful. Both emotions keep us stuck as mere observers reacting (or not reacting) to the symptoms of the problem.

Best to acknowledge why we feel this way and then work to change the status quo. There is much to be done that could structurally reform our financial system and make it safer than it is today, less prone to speculation and crashes that resulted in more than 5 million homes lost to foreclosure, persistent under-and-unemployment and a recovery that has benefit largely the upper echelon only.

Included on this list is the enactment of the bill championed by Senators Elizabeth Warren (D-MA) and John McCain (R-AZ) of the 21st Century Glass-Steagall Act. The preamble states that it’s mission is:

“To reduce risks to the financial system by limiting banks’ ability to engage in certain risky activities and limiting conflicts of interest, to reinstate certain Glass-Steagall Act protections that were repealed by the Gramm- Leach-Bliley Act, and for other purposes.”

In coming posts, I will explain what is in this legislation and how it is designed to remedy the years of deregulation that helped deliver the financial meltdown five years ago.

November 18, 2013

Welcome to the Perpetual Crisis Blog

In 2009 Fed Chairman Ben Bernanke defended the multi-trillion dollar bank bailouts that began under the Bush administration, explaining “it wasn’t to help the big firms that we intervened…when the elephant falls down, all the grass gets crushed as well.”

Today, the elephants are larger than ever and the grass is still crushed. The top banks are bigger and still borrow excessively in the short-term and overnight markets leaving them vulnerable to runs. But, let’s be clear. For most Americans, it’s not a question of when the next crisis will hit, but when this one will end.

Is the new normal for the U.S. economy a “permanent slump” as Paul Krugman suggested in a recent op-ed column? Krugman asked: “What if depression-like conditions are on track to persist, not for another year or two, but for decades?”

I hope you will join me here as I focus on what can be done to promote financial stability and shared prosperity.

October 30, 2013

Interviewed by Max Abelson, “Madoff Money to Japan Mob Ties Breed Banks’ Global Pains,” Bloomberg, October 30, 2013

Other People's Houses

Other People's Houses

In the wake of the financial meltdown in 2008, there were many who claimed it had been inevitable, that “no one saw it coming,” and that subprime borrowers were to blame.