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Can the Volcker Rule Survive?

After making a big splash with his proposed banking reforms in late January, President Obama sent a draft version of the bill to Congress last week.

Paul Volker
Scott J. Ferrell | Congressional Quarterly | Getty Images
Paul Volker

Among the most-discussed items is the “Volcker rule,” authored by former Federal Reserve Chairman Paul Volcker.

As we’ve talked about before in Investor Brief, the series of proposals from the President were designed to reduce the amount of risk banks take on, and one of the provisions would outlaw proprietary trading.

If you're not familiar with proprietary trading, it essentially means banks investing money to make more money. Different banks do this to varying degrees. Goldman Sachs has said a ban on proprietary trading could affect as much as 10% of net revenues.

In announcing the proposed Volcker rule on January 21, President Obama said that banks should "no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers."

In a recent trip to Washington, D.C., I talked with several high-level sources about this and other issues facing Washington and Wall Street, and I believe it is unlikely that the Volcker rule as initially proposed will make it into law. Formulating a precise enough definition of what does and does not constitute proprietary trading "unrelated to serving their customers" would be difficult at best and probably impossible.

Drawing the Line

Here's an example of what I mean: Suppose an institutional customer of a bank like JPMorgan says to the firm, "I have two million shares of stock X that I want to unload." Then, another big customer orders the sale of five million shares of the same stock X.

To fulfill orders of that size, JPMorgan in most cases would buy the stock from its customers and place the cash in their accounts. The bank would then be sitting on seven million shares of stock X that it would have to sell.

Those shares would now be sold from the bank's account, and this is where it could get very muddy. JPMorgan would probably have to unload such a huge block of shares in multiple transactions. (You're not often going to have a single buyer for such large blocks.) Over the course of those transactions, the stock's price would obviously fluctuate, so some sort of profit or loss is likely.

Would that be considered serving a customer? What if JPMorgan held the shares for a period of time because they thought they would get a better price? Or what if JPMorgan wanted to hold some or all of those shares in other funds or accounts?

JPMorgan would also not unload all that stock at once because it would flood the market and put selling pressure on the stock. The trade would have to be stretched out, making it even more difficult to know whether that’s considered proprietary trading or not.

One source that I spoke with, someone very high in the banking industry, said it best. This person would be directly affected by the Volcker rule, so I asked him what he thought about the debate over proprietary trading. He answered by asking me what he thought about what? He told me there are no details.

Committees in both the House and Senate are debating variations of the proposal that would allow regulators to restrict proprietary trading at specific banks if it were deemed to be a risk to the entire financial system or threaten the bank's safety. You would still have to define proprietary trading, but these less-sweeping versions probably stand a better chance of making it through Congress – and would likely be better received by Wall Street and investors.

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