Leaked Memo
Bankers, lobbyists and lawmakers from Wall Street to Washington scrambled to dissect, analyze and react to a leaked proposal for one of the most controversial elements of the Dodd-Frank financial-overhaul law: the "Volcker rule."
Billions of dollars are at stake for big banks, which have been working for months to shape the rule aimed at curbing risky trading activities that played a part in the financial crisis.
The latest frenzy erupted late Wednesday when a website posted a 205-page draft of a memo, dated Sept. 30, that laid out critical elements of the proposed Volcker rule.
The leak left regulators fuming and opened a new front in Wall Street's battle to soften the blow of the proposed rule. The draft gave banking industry lobbyists several days to discuss it before Tuesday, when the Federal Deposit Insurance Corp. is scheduled to consider issuing a version for public comment.
The response came quickly. A team of seven lawyers at the law firm Davis Polk & Wardwell, which represents a number of large banks, worked through the night in New York to ensure clients got briefings with their Thursday breakfast. Congressional staffers pored over the document looking for clues about how strict or lenient it could be.
Talk spread that the leak could prompt regulators to move more quickly to release an official version. A lobbyist for a large Wall Street bank assigned a staffer to continuously monitor the website of the Federal Reserve, which is helping draft the rule.
The rule is named for former Fed Chairman Paul Volcker, who argued that trading by banks for their own profit, an activity known as proprietary trading, encouraged financial institutions to take excessive risks.
A spokesman for Mr. Volcker declined to comment on the draft and said he will only comment when the official version has been released.
For years, banks racked up profit from proprietary-trading desks that acted in many ways like hedge funds. They made big bets on everything from stocks to commodities, often using borrowed money that amplified gains but also increased risk.
According to a July report by the U.S. Government Accountability Office, proprietary trading accounted for $15.6 billion in revenue at the six largest bank holding companies for the 13 quarters from June 2006 to December 2010, amounting to a fraction of combined revenue.
During five quarters spanning the financial crisis, however, proprietary trading accounted for $15.8 billion in losses, wiping out the gains of the previous 4½ years.
Congress effectively banned those activities in the Dodd-Frank law passed last year, but left it to regulators to write the rules implementing the law. Wednesday's leak was the first chance many bankers and lobbyists had to see how the rule is taking shape.
The Volcker rule already has triggered major changes at large U.S. banks. Several institutions shut down trading desks that made bets with the firm's own capital, and many of those traders moved to smaller firms that aren't subject to the rule. Its impact on the industry's profitability and risk-taking appetite will be hard to gauge until after the rule takes effect, likely sometime next year.
It is too early to estimate the rule's cost, but Glenn Schorr, an analyst at Nomura Equity Research, predicted it would "at a minimum" increase the cost of funding for U.S. companies, as banks pass on some of the higher expenses they face. The price tag for banks could be at least $2 billion a year, Mr. Schorr wrote.
The leaked document, posted on the American Banker website, was labeled as a draft and was authored by FDIC, the Federal Reserve, the Comptroller of the Currency and the Securities and Exchange Commission. After the FDIC's meeting Tuesday, the SEC is scheduled to meet Wednesday to consider the rule and the Fed is expected to follow suit as early as next week. The CFTC, which has been focusing on complex derivatives rules, is expected to take up the matter but has no immediate plans to consider the rule.
The draft memo set Dec. 16 as the deadline for public comments, but that date could be extended for several months.
One bank lobbyist Thursday noted that, while the rule language was couched in terms of avoiding disruptions to markets, it also contained language indicating that trading at banks "must be designed to generate revenues primarily from fees, commissions…or other income not attributable to appreciation in the value of covered financial positions it holds in trading accounts."
That could cause problems for bond-trading desks, where traders routinely build up inventories of bonds in anticipation of selling them for a higher price later to clients. Cutting this out of trading, some Wall Street pros fear, might shrink trading desks, hurting profit but also making it harder for investors to buy and sell quickly at competitive prices.
Meanwhile, officials inside the government agencies that drafted the document fumed about the leak. They worried that it could lead to pressure to change the language ahead of the FDIC's meeting next week.
Alternatively, the regulators could feel pressure to refrain from changes that could make it appear that they had given in to industry pressure.
As people drilled down into the details of the draft, many were concerned that it appeared to require very granular policing of individual traders at banks as part of the stringent, multilevel compliance regime described in the document.
"They have chosen the most burdensome way of doing it," said Tim Ryan, chief executive of the Securities Industry and Financial Markets Association, a Wall Street trade association, in an interview.
The more permitted market-making and other trading a bank engages in, the more intricate their compliance program will have to be. Among the many prescriptions for these compliance regimes: Banks with trading assets of $1 billion or more in trading assets and liabilities would have to measure their trading with a variety of quantitative formulas, and periodically report these metrics to regulators. The specific reporting requirements would vary by the scale and scope of a banks' trading activity, according to the document.
Trading units would have to calculate the required metrics each trading day, and report them on a monthly basis.
The proposed rule stops short of requiring a firm's CEO to attest to their company's compliance, which had been part of a set of recommendations made in January by the Financial Stability Oversight Council, a body that comprises top U.S. financial regulators and is headed by Treasury. Instead, the proposal asks for comment on whether such an attestation should be required. That is one of hundreds of questions posed by regulators in the proposal.
Among the more controversial elements of the rule is a provision that would allow banks to make trades described as hedges, or bets that offset other positions, on a "portfolio basis." The rule would include "the hedging of one or more specific risks arising from a portfolio of diverse holdings, such as the hedging of the aggregate risk of one or more trading desks."
Such trades would have to be "demonstrably risk-reducing," according to the document.
The language is seen as a victory for Wall Street banks, which have long favored such language. The Wall Street Journal previously reported that a draft of the rule that emerged in August included language allowing for portfolio-style hedging.
Critics say that by allowing banks to hedge risks on a portfolio-wide basis, the rule could open the door to more aggressive trading tactics. A bank could claim that its portfolio is at risk from an economic turn, such as a recession, and take positions that protect it from such an event, they say.
Such nuances are likely to take years before banks, regulators and law makers know how the rule will be applied in practice.
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