Should hedging regulation be tightened?

{mosads}A key element of Section 619 of the Dodd Frank Act, known as the Volcker Rule, is its prohibition on proprietary trading on the part of banking entities. According to the Financial Stability Oversight Council, the purpose of the prohibition of proprietary trading is threefold: To separate speculative trading from federal support of the banking system, to reduce conflicts of interest, and to reduce risk to banking entities. Recognizing that a complete ban on trading can potentially cause more harm than benefit, the Volcker Rule allows banking entities to engage in trading related to risk-mitigating hedging, as well as other activities such as underwriting, market making, and trading on behalf of clients.

The challenge that regulators face – and it is a significant challenge – is how does one evaluate whether a bank is truly engaged in hedging? Hedging is a subtle and complex art, and supposedly risk-mitigating activities can lead to exposures that are instead risk-enhancing, as the JPMorgan example demonstrates. One approach is extremely rigorous oversight of hedging activity, through documentation and examination of each trade to ensure that the trade is, indeed, risk-mitigating and offsets the gains or losses that occur when a bank is exposed to a risk factor. While the impulse to tighten regulation related to hedging in response to negative headlines is understandable, I believe that these attempts can backfire. 

Here are some examples of how tighter regulation can backfire: If the regulation of hedging is oppressive banks may avoid hedging exposures as they perceive doing so is too troublesome. This will result in riskier banks – in direct opposition to the objective of reducing risks.  Or, the rules may be so onerous that the bank may choose to avoid lending to, say, a corporate borrower that it would have otherwise been willing to lend because the rules make hedging of the resulting exposure too onerous – effectively reducing the borrower’s access to funds, a clearly negative consequence. Further, setting detailed guidelines can turn the bank’s focus away from the need to calibrate exposures appropriately and towards a focus on satisfying regulatory rules. Indeed, the rules – and the loopholes that will inevitably be found – can be used as an excuse for hedging failures and as a way to avoid responsibility.

Rather than trying to tighten the hedging exemption, I recommend that regulators recognize that the markets do a decent job of disciplining those that fail when hedging. The JPMorgan example demonstrates this clearly, as the stock price declined in value and executives faced public outcry, reputational and career risk, and scrutiny by politicians and regulators. While insufficiently exacting to those more zealously in favor of tighter regulation, these consequences are very real to banks. Given the costs associated with tighter regulation of hedging, I believe that reliance on market discipline – with all of its messiness – is a wiser approach than tighter regulation.

Gottesman is an associate professor of finance at the Lubin School of Business at Pace University.