Regulators decline to water-down the Volker rule. MF Global shows why.

The Dodd-Frank Act’s Section 619 was proposed by former Federal Reserve Chairman Paul Volcker as a way to separate commercial banks from proprietary trading and private investment fund activities. The rationale was that federal guarantees should not support risky trading activities. The Proposed Rule could have a severe impact on trading or fund ownership or control by banking institutions.

The Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission recently issued long-awaited guidance.  The guidance is quite detailed, running around 300 pages. There were not too many surprises in the Proposed Rule.

As proposed, the Volker rule prohibits a covered banking entity (“CBE”) from proprietary trading, and from investing in or controlling private equity or hedge funds. The Proposed Rule allows banks to accommodate trading or fund sponsorships for the benefit of, and where the underlying risks are borne by, customers. If the activities are not for customers, then the activity is forbidden.

The Proposed Rule permits certain kinds of short-term trading in connection with underwriting, market-making, and hedging activities so long as a CBE generates returns on these programs largely through fees and other compensation reflecting the services provided, and not through gains on ownership interests. The theory is that trading in these contexts does not present the speculative risks present in stand-alone proprietary trading

On November 1, 2011 MF Global filed for bankruptcy protection. This bankruptcy was caused by highly-leveraged proprietary positions that MF Global took in European debt that since plummeted in value. But, the losses at MF Global, while certainly large and painful for those who have a financial interest there, did not cause larger problems. This occurs because MF Global is not a bank, and was not playing with public money. Those who would have wanted the Volker rule to be amended or withdrawn lost a big portion of their argument upon MF Global’s failure. There is nothing wrong with proprietary trading so long as it is kept from federally-insured, deposit-taking banks.

July 21, 2012 is a hard deadline for when the Volcker Rule is to take effect, whether the regulators issue their related rules or not.


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