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Volcker Revision Lets Toxic To Retain And Reflate At Banks, By Kelvin To, Founder And President Of Data Boiler Technologies

Date 22/10/2018

The FED, SEC, CFTC, OCC, and FDIC (collectively, the “Agencies”) are rounding out public comments on their proposed revision to the Dodd-Frank Volcker Rule. Below table highlights some loopholes hidden in the details:

Subterfuge” of the Agencies’ proposal Implications
Accounting prong + trading account/ desk redefinitions Wide open backdoors (especially Subpart B §_.3(d) liquidity management exclusion) to proprietary trading
Reliance on internal set limit (Subpart B §_.4(b), (e)). Eliminate the need for a definition for “market-maker inventory”. No longer require banks to conduct a demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with positions in financial instruments (remove purpose test/ short-term prong). Downplay risk of unreasonable activities amid cases of blindsided risky positions and dodged regulatory oversight. Trade under the guise of market-making exclusion even it would not fit the SEC’s market-making definition per se. Indirectly weaken stance against “conflict of interest” (Subpart B §_.7(a)) when controls may be bypassed through transfers in-and-out of category between available-for-sale and hold-till-maturity and/or a flipping-switch between dealing with “client” versus “counterparty”.
Sub-B §_.3(c) Presumption of compliance  Eliminate problem by turning a blind eye to it ® no demonstration of how exclusions are qualified, which affects §_.4(c), (d), (f), (g)  
Reservation of authority on high-risk assets and high-risk trading strategies Trim almost everything, the residual “High-Risk Asset” and “High-Risk Trading Strategy” (Subpart B §_.7(b) Backstop provision) is hard to enforce
Carve-out ASC-815 derivatives + no correlation analysis  + demonstrably reduce (or otherwise significantly mitigate) risk be removed Invite gaming of control (§_.4(h) and  §_.5(b)), use of instruments and inventory level are unaccounted for, risks not “specified” ® bets and abuses to cover/ hide losses, violate Fed Reg. 5542
Remove §_.20(c) Appendix B + replace ownership test with vague fund characteristics, carve-out non-traditional structured Hedge Funds / Private Equities Allow toxic to retain and reflate at banks, circumvent sponsor limit, opposite the President’s “America First” principles
Cost-benefit justifications It is the deposit insurance mechanism ($2 billion/ year + cost to bring banks into conformance with FDIC) that out-weighted its benefits ($73.1 to “move” every $100 for resolution disbursements in the past 5 years), not Volcker.

 

The Agencies’ proposal is like “putting the cart before the horse” to retrofit banks’ flawed risk management frameworks as Volcker revision, because such “risk approach” has proven to be ineffective during the last financial crisis. The proposal will reverse years of effort by Troubled Asset Relief Program to “separate out the bad bank” and allow toxic to reenter the banking system benefiting merchants of “junks” whom have little or no skin in the game.

According to St. Louis FED, “U.S. commercial banks holding of treasury and other U.S. agency securities doubled to $2.4 trillion compared to nine years ago”, it fills a vital money gap where U.S. faces massive sell-off of treasuries from foreign creditors (see this). Volcker’s favorable policy has made the U.S. government debt less depending on foreign countries, such as China. Tragically, the Agencies’ top officials overlooked the Rule synchronization with President Trump’s “America First” principle. Consequently, the Agencies’ proposal would inadvertently push banks to abandon prudent investment in U.S. Treasury and other U.S. Agencies securities. As a result, it will cause an “irrational exuberance” if banks recklessly pursuit higher yields in risky and illiquid products, which is unsustainable. The timing could not be more disastrous amid the largest budget deficit in the U.S. history and flatten (possible inversion) of yield curve!

To address a 2008 liked crisis, the Agencies should holistic review the outdated deposit insurance mechanism because it is unfit for the 21st century challenges (flash crashestoo-big-to-fail, and financial engineering abuses in particular). Unfortunately the FED is proposing to relax capital rule in parallel with Volcker revision. Hence, there won’t be adequate capital to address the short comings of deposit insurance (moral hazard in particular). The Volcker Rule not only fills this policy gap, it also addresses the too-big-to-fail issues if implement properly. We advocate for using innovative RiskTech and BPO to:

  • Gauge “reasonableness” in securities inventory each day via an empirical RENTD calculator;
  • Distinguish permissible versus prohibited activities, and prevent bypassing of controls via automated surveillance;
  • Monitor the banking entity’s investments in, and transactions with, any covered funds.

The current and proposed metrics are not effective to deal with rapidly evolving issues proliferated by hidden problems and silos. If trade activities can consistently be scrutinized per our suggestions, then the Agencies may publicize the percentage of suspicious trades being “red-flagged” to enhance transparency of the Rule’s implementation. This would essentially eliminate all metric requirements, except the Agencies may ask for, or commission a “comprehensive profit and loss attribution study* when symptom of control weakness is identified by the surveillance system. Besides, we see an opportunity to streamline the Rule’s covered fund provision by rewritten it to become the 21st Century Glass-Steagall Act (i.e. prohibited banks from participating in hedge funds, private equity funds, and the like businesses). To ensure shifted risks won’t come back to haunt banks, one should consider the use behavioral science to ensure “exit only, no re-entry” – like “letting go” of bad habits or toxic assets.

Finally, the Volcker Rule’s preventive approach is better than salvaging a troubled bank through other regulatory measures. This is because “demonstrate compliance” is helpful to restore a healthy hierarchy of diversified banks, so that tier-two banks would be ready to step-up in case a failed global systemically important bank is under stress. Bottom line, it is all about streamlining the right priorities to save costs and foster control improvements to achieve the Rule’s financial stability goals, I afraid that’s not the case in the Agencies’ proposal. Please see the full comments that I have submitted to the Agencies in here.