How to clear some of the smoke on the Volcker Rule

Haziness and the Volcker Rule

The Volcker Rule is a bit hazy...

Over the past couple years there has been a lot of talk about the Volcker Rule. Basically this rule prohibits banks from taking safe assets and putting them up against liabilities as a result of proprietary trading. Essentially, the idea is that if you deposit money in the bank, you shouldn’t have to worry about the FDIC backing your deposits as a result of your bank engaging in trading that may tumble. The problem with this is defining what’s market making and what’s proprietary trading.

When it comes to equities, most equities at least, is that there is generally a good market for them. And for the ones that are illiquid, it doesn’t require much capital to hold to them. But with bonds and and other instruments, it requires a large amount of capital to hold on to these positions. By limiting the amount of money banks have to hold these positions, you will be holding back the amount of money they can spend on certain instruments, most notably municipal bonds and non-US sovereign bonds.

The latter is a significant problem because holding back on holding back certain instruments may upset some countries. How would large growing economies respond if the US started to suddenly sell their bonds? Given that it will actually increase their interest rates but decrease exchange rates. This helps because it makes their exports cheaper but also increases their borrowing costs. For smaller emerging economies, the effect on their interest rate will be less, essentially making it a good thing because they are more able to compete with the US while not raising their borrowing rates dramatically.

This isn’t calling the Volcker a complete disaster. There are solutions. Instead of making banks sell these positions, why not require them to hedge against them? Make them buy credit default swaps on some of the riskier debt. Now the problem with this being that to purchase credit default swaps, which is essentially a put option on interest rates, is that someone has to take the other side. Plenty of mutual funds now will also have a problem with the Volcker Rule. But they could also engage in the CDS market to take the other side of trades. Which saves AIG from drowning again.

Maybe it’s not a perfect solution, but it’s a start.

Links:
http://www.cfainstitute.org/newsletter/advocacy/volcker_rule.html
http://www.cfainstitute.org/Comment%20Letters/20120215.pdf

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