Saturday, January 21, 2012

The Volcker Rule would not have prevented bank failures

Further confirmation of risks to liquidity posed by the Volcker Rule came a couple of days ago in the Congressional testimony by the Securities Industry and Financial Markets Association (SIFMA).
The impact of the regulations will have broad implications. The ability of corporate issuers to raise capital in the U.S. by selling their debt securities is dependent on the availability of secondary market liquidity, which is largely provided by banking entities through their market making activities. We are convinced that the proposal will significantly reduce the liquidity of the secondary market for debt securities and is likely to have a profound and unintended adverse effect on our capital markets. The U.S. economy will be forced to bear both short-term and long-term costs associated with the reduction in market liquidity that will result from an overly restrictive interpretation of the Volcker Rule.
It is still unclear what the regulators are trying to accomplish with the Volcker Rule. The only two large US bank holding companies* that failed in 2008 were Citibank and Wachovia. In structuring CDOs these firms sold the lower rated CDO tranches (that had "attractive" yields) to investors. But in order to create these tranches, the banks had to also create massive amounts of "AAA" (providing "leverage" for the lower tranches to boost the yield). Since the "AAA" tranches had low yields, it was difficult to place them, so the banks retained many of these bonds. But rather than putting them on their balance sheet, they employed off balance sheet CP conduits and used the asset backed commercial paper (ABCP) markets to fund these positions. This was known as the "regulatory capital arbitrage" - a concept US politicians still fail to grasp. The failure of the ABCP market in 2007 forced these banks to take the "AAA" tranches onto their balance sheets which ultimately led to their failure. But all of these activities were meant to facilitate the CDO business and had nothing to do with "proprietary trading". Therefore the Volcker Rule in its current form would not have prevented bank holding company failures.

  SIFMA Testimony on Volcker Rule

* Note that WAMU failed because it was overextended on its mortgage loan portfolio (unrelated to prop trading), Lehman and Bear were not banks and failed because they could not roll their repo financing, and AIG was effectively an unregulated insurance firm, not a bank.
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