Dodd-Frank reform requires surgical precision

Goldman Sach’s letter last week to federal agencies about Volcker Rule reforms demonstrates its position along the fault line between those who believe systemic protections are still needed versus those who feel post-crisis regulation is too restrictive.

Goldman, unsurprisingly, wants the rule, which prohibits banks from making certain proprietary investments, weakened and believes amendments proposed earlier this year by regulators do not go far enough to provide relief.

Based on the Federal Reserve’s recent statement in favor of cutting burdens on banks with less than $700 billion in total assets, they apparently aren’t alone in rethinking the Dodd-Frank Wall Street Reform Act.

Perhaps they are both right. But we all would do well to remember the bailouts that prompted this sometimes-overheated regulatory response.

Those bailouts of large, complex and politically well-connected financial institutions came at great taxpayer expense and often against taxpayers’ wishes. The rules Goldman and the Fed now think need weakening were created amid this dynamic.

A key component of that response, and Goldman’s current ire, was the so-called Volcker Rule. Its specific purpose was to address the big banks’ use of insured deposits to engage in securities and derivatives trading and to invest in leveraged private equity and hedge funds.

Banks’ activities in these areas weren’t the proximate cause of the crisis — mortgage lending took that dubious honor — but they certainly added to the anxiety over the financial system’s potential collapse.

The rule was proposed by former Federal Reserve chair Paul Volcker, who said banks should be banks. He argued that banks should no longer engage in speculative trading on their own investment accounts because trading placed the entire bank and customer deposits at risk.

Aggregated across even a small number of very large institutions, these risks put the government (i.e., taxpayers) on the hook for making good on those Federal Deposit Insurance Corporation(FDIC)-insured deposits. Thus, the Volcker Rule was born.

The return of record-high markets has some bankers thinking the rule may have outlived its purpose. A greater number believe the reach of its onerous tentacles has stretched beyond its original target — the banks whose trading put the deposit insurance fund at risk — and into the limited securities activities of small and mid-sized banks.

Some of these concerns are legitimate, and a review of the means of achieving the proprietary trading ban is certainly appropriate. The rule has reduced liquidity in corporate and municipal bond markets, as well as in the markets for over-the-counter derivative products used for risk-management.

It affects the securities trading services banks offer to their customers and may even influence the willingness of banks to make trades in securities designed to hedge their own business risks, leaving the banks potentially more vulnerable to market gyrations.

In each of these scenarios, the banks fear their market-making and hedging trades will trigger unwanted regulatory scrutiny and run afoul of the Volcker Rule’s prohibitions.

Given the detailed and costly compliance reporting that entails, bankers can simplify their lives by just avoiding the trading, whether or not such trading is proprietary. Taking this route, however, may cause banks to miss opportunities to compete globally, service clients and grow their businesses.

Although some easing of the Volcker Rule may be in order, sounding the “all-clear” would be treacherous. Among the proposed revisions would be, in simple terms, the full delegation to the banks on whether a trade is made for hedging or market-making purposes. To us, that sounds like a fox-guarding-the-henhouse scenario.

Problems arise when banks’ affiliated brokers have the ability to trade into and out of huge inventories of securities in the guise of expected customer demand.

What is critical is to prevent banks from getting caught holding such inventory during a market collapse, as was the case in 2008. Recall the urgent sounding of reveille from the Federal Reserve if you need a reminder of just how high the “systemic” stakes can be.

A more worrisome possibility is the potential for a bank to misjudge demand, speculating in and out of these positions in a fashion nearly identical to proprietary trading. Likewise, hedge trading can be almost indistinguishable from proprietary trading.

The prospect for engaging in what is essentially prop trading in disguise, and the ability to do so quickly, with less-detailed accountability and more regulatory deference, is a risk we should avoid.

The revisions to the Volcker Rule seek to negotiate a delicate balance. If it is too strict, important players in providing market stability and liquidity may be impaired; if it is too loose, the players will conduct banned proprietary trading in the name of market making and hedge trading.

In our recent letter to regulators on these proposals, CFA Institute supported rollback of the rule’s reach into the limited securities activities of most small and mid-sized banks, while retaining the strict oversight and reporting requirements placed on banks with large and active trading operations.

And we, like the Systemic Risk Council, worry that some of the planned rollbacks are imprudent by relying too much on the prudence of bank management.

The markets are in better shape now than they were a decade ago when the financial crisis nearly consumed the global financial system. They are even better than they were when the Dodd-Frank Act’s attempts to prevent a recurrence of the crisis were adopted into law.

But policymakers would be well-advised to avoid misinterpreting serene markets as a sign that we can relax protections against banks’ proprietary trading. Taxpayers’ goodwill will only go so far.

Kurt Schacht is managing director of the CFA Institute, a global association of investment professionals that offers the Chartered Financial Analyst (CFA) designation.