Bank Rules That Serve Two Masters

When there are two powerful factions in Congress, one of which wants to take an action and the other of which wants to avoid it, what should Congress do?

Mary L. Shapiro
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Mary L. Shapiro


As the rules get written for Dodd-Frank, the financial reform law that Congress enacted last year, the essential contradictions in the law are being left to regulatory agencies to sort out. Whatever they do, you can depend on legislators to say the regulators are ignoring Congressional intent — or at least the intent of one faction or the other.

Consider the Volcker Rule, named for its chief proponent, Paul A. Volcker, a former chairman of the Federal Reserve. It prohibits banks from engaging in proprietary trading.

If that sounds straightforward to you, you may not have read the rule, or the new 298-page effort by regulators to figure out how to apply it. That effort produced howls of anguish from those who liked the idea of the rule, and similar reactions from those who hated it.

Some might say the equal disdain shows that the regulators are trying to steer a middle course. It might be more accurate to say they were given an impossible task.

A similar fight is going on over “skin in the game” rules for mortgage risk retention. The law says that lenders who sell mortgages to investors should retain some of the risk.

That seemed wise after the bad loans fiasco that helped bring down both the banking system and the economy.

But the law also says that those rules should not apply to especially safe mortgage loans, called qualified residential mortgages in the law. It is up to the regulators to figure out which is which.

In each case, those who want tougher rules point to the risks that came home all too clearly in 2008 and 2009. Banks and some of their customers say the economy, and bank profits, will be hurt if rules bite too deeply.

The Volcker Rule, as enacted, “generally prohibits banking entities from engaging in proprietary trading,” as the regulators stated in their opus this week. But the law goes on to provide exemptions for such things as “trading on behalf of customers,” “risk-mitigating hedging activity” and “underwriting and market-making activities.”

And there are exceptions to the exceptions. As Mary Schapiro, the chairwoman of the Securities and Exchange Commission, explained, “These otherwise permitted activities are not permitted, however, if they involve material conflicts of interest, high-risk assets or trading strategies, or if they threaten the safety and soundness of banking institutions or U.S. financial stability.”

In other words, you can’t tell the difference between a prohibited activity and an allowed one just by looking at what a bank did; you have to instead divine its purpose. Then, even if the purpose is worthy, you have to decide if the risk is too high.

The logic behind the Volcker Rule is that banks are special, and should not be able to do some of the things other market players are free to do. Banks are special because they benefit from government-insured deposits. Big banks are even more special because if they gamble and lose, it may be the government that ends up with the loss, via a bailout.

But banks also provide a lot of services beyond just taking deposits and making loans. Customers want those services to continue to be available.

The rules proposal this week does not claim to be complete. The document lists 383 questions for those commenting on the proposal to consider in recommending changes. Some of those questions have multiple queries. Here’s one example:

“Question 19. Is the exchange of variation margin as a potential indicator of short-term trading in derivative or commodity futures transactions appropriate for the definition of trading account? How would this impact such transactions or the manner by which banking entities conduct such transactions? For instance, would banking entities seek to avoid the use of variation margin to avoid this rule? What are the costs and benefits of referring to the exchange of variation margin to determine if positions should be included in a banking entity’s trading account? Please explain.”

Longing for Glass-Steagall

I think the question has something to do with deciding whether to classify a given position as being proprietary trading — and thus a no-no — or hedging — and thus perfectly O.K.

You may have noticed that this column keeps referring to “banking entities,” not to banks. There are extensive rules aimed at deciding if something is a banking entity or not.

It makes me long for the old days of Glass-Steagall, when there were fairly clear rules on what banks could and could not do. But that is not what Congress legislated.

The proposed Volcker regulations try to come up with a bunch of “metrics” to help decide whether a trade is proprietary or not. They demand that the bank’s board create policies and procedures to assure that what the bank is doing is not proprietary trading. The rules borrow from bank capital rules, which generally say that trading positions are subject to lower capital charges than positions that are intended to be held for a long time. The idea is that if you say it gets the lower capital charge, then maybe we won’t allow it.

All this may work via the hassle rule. It may be so much hassle that it is not worth the effort for banks to evade the rules. But if banks want to test the limits, there is likely to be plenty of latitude for regulators to be tough. Or not.

The “skin in the game” rule for securitizing mortgages, however, will end up being far less subjective. Those who value risk retention have already lost one major battle, and may yet lose another.

The regulators issued their proposal in March, and the comment period has closed. It is not clear when they will come up with a final rule.

The Dodd-Frank law specified that at least 10 percent of the risk from a securitized mortgage should be retained, but was a little vague on who should retain it. The proposed rule interpreted that in a way to eliminate risk retention for most mortgages: if a mortgage is securitized by the government-controlled agencies, Freddie Mac or Fannie Mae, there is no need for anyone who was involved in issuing the mortgage to retain any risk. The agencies are retaining it, so investors are protected.

Who will protect the agencies, who ended up guaranteeing some very dicey loans in the bad old days? They will have to do it themselves, with their presumably improved procedures for accepting mortgages.

For private-label securitizations, a market that has yet to revive, the proposed rule was tougher. Someone — the lender or the bank that put the securitization together — would have to retain at least 10 percent of the risk unless the mortgage was really, really safe. A qualified residential mortgage would have to have a down payment of at least 20 percent, and no more than half of that could be borrowed.

That set off a wave of complaints, with real estate agents and home builders persuading consumer groups to join them in outrage. They seem to assume that no one will ever make a mortgage loan if they have to retain risk, so qualified residential mortgages should basically include every loan anyone would ever dream of investing in.

If lenders ever decide to make negative amortization loans for 125 percent of the assessed value to people without jobs or assets, then maybe there would be a nonqualified mortgage.

It is at least possible that there will not, in the end, be any skin in the game. The opponents of the idea say it would damage an already suffering housing market, and hurt people who need loans the most.

Of course, both the market and the people would be a lot better off now if easy loans to unqualified borrowers had not been made in the past, but opponents of risk retention do not focus on that. And it is also possible that investors may not want to take part in a new securitization market if there are no risk-retention safeguards in place.

If the risk-retention law is gutted by regulation, it will be partly the fault of regulators giving in to pressure. But it will also be the fault of a Congress that was determined to have it both ways.