How a Volcker Rule rewrite could backfire

WASHINGTON — Critics of the Volcker Rule may be heartened by recent indications that policymakers are prepared to finalize a more bank-friendly version the proprietary trading ban soon, but that relief could come at a price.

The rule is one of the most vexing regulations for the industry to emerge from the Dodd-Frank Act. Yet a Bloomberg report this week, citing unnamed sources, said regulators are close to finalizing a revised compliance framework that would make it much easier for banks to distinguish prohibited trades from legitimate ones.

It followed last week’s released of data by the Office of Financial Research that bolstered the industry’s case for relief by showing that the trading ban has sapped market liquidity.

But since any dramatic step to weaken the rule will be seen as a gift to the largest banks, it could play into a narrative that the Trump administration’s deregulatory agenda favors big business. This could amplify the rhetoric of Democrats running in the 2020 presidential election.

Andrew Harrer/Bloomberg

The Volcker Rule was meant to address a problem first raised by former Federal Reserve Chairman Paul Volcker in the wake of the 2008 financial crisis: that there was nothing to prevent banks from using customers’ government-backed funds to enrich their proprietary portfolios. His solution — and the one that was ultimately adopted into Dodd-Frank — was to eliminate those portfolios, thus eliminating any conflict of interest.

Of course, the ban is harder to execute in practice. In addition to trades targeted by the ban, banks hold securities and other vehicles in order to generate markets that might not otherwise exist. The regulatory agencies took that consideration into account when they finalized the Volcker Rule in 2013, creating a market-making exemption. But threading the needle on what kinds of activities qualify for that exemption and which do not has dogged banks and regulators ever since.

The regulatory agencies have appeared serious about refining the compliance framework, but it is not completely clear which avenue they will take.

They released an initial proposal last year that would mostly affect banks with the largest exposures, focusing improving certain definitions to determine which trades are banned. But banks were not impressed, while Wall Street critics and other observers said the revisions could be inferior to the existing regime.

Some have speculated that regulators will submit a new proposal or finalize non-controversial aspects of the original proposal. Yet the Bloomberg report suggests the agencies are prepared to go further to meet banks’ demands. That potential outcome seemed even likelier Tuesday afternoon when the Federal Deposit Insurance Corp. announced a board meeting for Aug. 20 to consider a “final rule” dealing with revisions to the proprietary trading ban.

Yet any moves to weaken the Volcker Rule should weigh the potential effect on how the Trump administration’s bank regulatory agenda will play in the 2020 election. It could serve as a political foil for Democrats who have already railed against “big-bank giveaways.”

Sens. Elizabeth Warren, D-Mass., and Bernie Sanders, I-Vt. — currently polling second and third in the Democratic primary — have made their names by decrying the excesses of corporate America, including big banks. Warren, who sits on the Senate Banking Committee, has made a particular point of pressing regulators to make banking regulations more stringent, and has laid the groundwork to make those regulations a big part of her campaign message.

Up to now, many of the regulators’ proposals to revisit the post-crisis regime have been focused on offering relief to smaller and midsized institutions, leaving the larger banks’ regime relatively unchanged. This made it harder to argue that the Trump administration’s agenda is a giveaway to Wall Street.

The Volcker Rule, however, could be different. Last year’s regulatory relief bill eliminated Volcker Rule compliance requirements for community banks, meaning that any revisions to the rule that are significantly more favorable to banks than last year’s proposal could be more credibly portrayed as a big-bank giveaway on the campaign trail.

How a Volcker revision is spun on the campaign trail depends entirely on what is different in the new Volcker Rule compared to last year’s proposal and the existing regime. Whatever emerges from the regulators in the coming weeks, politicians will be watching.

Bankshot is American Banker’s column for real-time analysis of today's news.