Banking Industry Revamp Moves Step Closer to Law

Wall Street is bracing for major changes from a new rule that would overhaul how the banking industry conducts its trading.

Wall Street sign
Wall Street sign

The Federal Deposit Insurance Corporation unanimously approved on Tuesday an initial version of the regulation, known as the Volcker Rule. Two other regulators followed suit, and the Securities and Exchange Commission is scheduled to vote on Wednesday.

The rule, intended to limit trading when the bank’s money is at risk, a sweet spot for banks, is seen as a centerpiece of the sprawling financial overhaul of the Dodd-Frank Act of 2010. In anticipation, the nation’s biggest banks, like Goldman Sachs and Bank of America , have already shut down their stand-alone proprietary trading desks.

But the proposal on Tuesday included several unfriendly surprises for the banks, including provisions that scrutinize how they generate revenue, award compensation and track their compliance with the Volcker Rule. Such measures, analysts say, could significantly change the way Wall Street does business.

“You’d have to go back to the New Deal for a rule that would have as profound an impact on the financial markets as the Volcker Rule,” said Donald N. Lamson, a former Treasury Department official who helped write the Volcker Rule into Dodd-Frank. “If you add it all together, it’s going to increase costs, decrease revenue and profits and potentially scare off your most productive employees,” said Mr. Lamson, now a lawyer at Shearman & Sterling.

With regulators blessing the first draft of the rule — named after Paul A. Volcker, a former Federal Reserve chairman and former adviser to President Obama — the fight over its esoteric details kicks into high gear. The deadline for public comments on the proposal is now Jan. 13; the final version takes effect next July.

"You’d have to go back to the New Deal for a rule that would have as profound an impact on the financial markets as the Volcker Rule." -Former Treasury Department official, Donald N. Lamson

“I expect the agencies will move in a careful and deliberative manner in the development of this important rule,” Martin J. Gruenberg, acting chairman of the F.D.I.C., said on Tuesday.

More than a year after Dodd-Frank became law, much is still unknown about the Volcker Rule. The proposal introduced on Tuesday in some ways raises more questions than it answers. In the 298-page document, regulators posed nearly 400 questions for the industry and the public to consider, leaving room for significant changes.

”Unfortunately, the resulting uncertainty will have an enduring and negative impact on the banking industry and the customers we serve,” Frank Keating, president and chief executive of the American Bankers Association, said in a statement.

For now, the rule’s supporters and critics alike are frowning on the proposal that emerged on Tuesday. Consumer groups want to make it tougher. Wall Street has been lobbying furiously to tame the Volcker Rule, holding roughly 40 meetings with various regulators, warning that the changes will eat into profits at a difficult time for banks.

“The banking industry fears the oversized nature and complexity of this proposed rule will make it unworkable and will further inhibit U.S. banks’ ability to serve customers and compete internationally,” Mr. Keating said.

Some aspects of the proposal, financial industry lawyers and lobbyists say, challenge the very nature of Wall Street. For one, the rule would prevent banks from awarding bonuses intended to “encourage or reward proprietary risk-taking.”

The proposal also requires banks to generate revenue primarily from fees and commissions rather than from the fluctuating value of securities they hold. In essence, the move would upend the banking industry’s lucrative, yet risky trading system, forcing powerhouse investment banks to resemble sleepier brokerage firms.

Answers to a fundamental question surrounding the Volcker Rule — namely, how will it be enforced — provided little comfort to Wall Street on Tuesday. The proposal spells out an expansive internal control regimen that banks must adopt, creating layers of expensive and time-consuming compliance. Under the rule, banks must turn over a battery of information to regulators, including a number of metrics to gauge whether a bank is helping clients or trading for its own benefit. The proposal itself, citing survey data, estimates that banks will have to spend more than six million hours putting the rule into effect.

“The onus is absolutely on the banks,” said Kim Olson, a principal with Deloitte & Touche who is both a former regulator and banker.

While the proposal stopped short of forcing bank chiefs to certify the legitimacy of their compliance program, regulators asked the public to comment on the possibility of “C.E.O. attestation.”

Regulators also raised the possibility that banks might turn over their data to independent warehouses, where regulators could keep an eye on the trading.

As Wall Street grumbles over the scope of the Volcker Rule, some Democratic lawmakers and consumer advocates are pushing for even tougher restrictions.

“Unfortunately, this initial proposal does not deliver on the promise of the Volcker Rule or the requirements of the statute,” said Marcus Stanley, policy director of American for Financial Reform, an advocacy group.

During the lengthy rules-making process that led to Tuesday’s draft proposal, a number of controversial exemptions emerged.

While the regulation prevents big banks from placing bets on many stocks, corporate bonds and derivatives, it exempts trading in government bonds and foreign currencies.

The proposal also provided a path for getting around the ban, for instance, when banks hedge against risk that comes from carrying out a customer’s trade. Market-making and underwriting are excused, too, though the line is often fuzzy between these pure client activities and proprietary bets.

Proprietary trading, analysts say, often slips into client-focused activity. Banks, as part of routine market-making, can buy securities from one customer with the intent of selling them to another client. The Volcker Rule proponents want to close certain loopholes in the rule, particularly the broad exemption for hedging. The proposal unveiled on Tuesday would allow banks to hedge against theoretical or “anticipatory” risk, rather than just clear-and-present problems.

“The vagueness of the proposal, and the hundreds of questions it includes, also demonstrate that we are still in the middle of this process,” Mr. Stanley said.