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Prasenjit Das

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Prasenjit Das - NIIT Technologies Limited

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Why delay in Volcker rule may not be unreasonable ?

10 February 2015  |  2197 views  |  0

 

 

The   Federal Reserve delayed by two years compliance with the Volcker rule that bans them from betting with their own money through investments in risky hedge and private equity funds. However the delay did not affect the ban on proprietary trading, which Banks’ must stop by July 21, 2015. 

Acting under the provisions contained in section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as the Volcker Rule the Federal Reserve Board gave banking entities until July 21, 2016 to conform investments in and relationships with covered funds and foreign funds that were in place prior to December 31, 2013 ("legacy covered funds"). It also announced that it intends to act next year to grant an additional one year extension thereby giving a two year period until July 21, 2017. 

Section 619 authorizes the Board to extend the conformance period for one year at a time, and not more than three additional years in total .As laid down in the act Section 619 of the Dodd-Frank Act provided banking entities a grace period until July 21, 2014 to conform to its requirements. The first extension given was given until July 21, 2015. The Banks’ had pressed hard for the concession, contending that they could suffer big losses if they had to sell the stakes and Fed’s argument that markets could be roiled if the Banks’ had to sell their fund investments by July 2015 is contested. 

In a statement issued by Mr. Volcker in the aftermath of the delay reads “It is striking that the world’s leading investment bankers, noted for their cleverness and agility in advising clients on how to restructure companies and even industries however complicated, apparently can’t manage the orderly reorganization of their own activities in more than five years,” Mr. Volcker said, “Or, do I understand that lobbying is eternal, and by 2017 or beyond, the expectation can be fostered that the law itself can be changed?” 

Banks’ do have substantial challenges and may probably find some respite in the space provided by the Fed ‘reprieve’ .Such may arise from challenges posed by the Dodd Frank Act, Basel III and others from the regulatory perspective besides a host of business challenges which impacts Banks’’ bottom-line and top line which is touched upon below 

 

 Proprietary trading versus market-making and hedging 

It is not possible at least simple to distinguish between the two without impairing one or the other. Market-making and hedging is nothing but principally buying and selling debt securities which resembles proprietary trading which Volcker rule seeks to prohibit. The activities involved in market-making and hedging is buying and selling debt securities which have the potential to be mistaken to be proprietary trading. Similarly JPMorgan Chase lost over $6 billion which the bank (“London Whale”) said was a hedge against possible losses on a large portfolio of EU securities. A contrast view was that the hedge was a fake, a cover for a proprietary trade that went awry. So hedges themselves can be subject to differing interpretations. 

 

 Trading of securities versus investing in securities 

There has never been any evidence that the proprietary trading of securities had anything to do with the financial crisis. Rather it was investing in securities .To be specific securities backed by subprime and other low quality mortgages. The subprime crisis was triggered by a large decline in home prices, leading to mortgage delinquencies and foreclosures and the devaluation of housing-related securities. Declines in residential investment preceded the recession and were followed by reductions in household spending and then business investment. 

This is all in contrast to the popular perception that the financial crisis was triggered by trading in such toxic securities. 

 

Trading securities versus lending 

Lending is as riskier as trading securities. A bank commits cash to the control of the counter party for an extended period of time and the bank seldom has effective control over the way the borrower uses the funds .The possibility of loss being always inherent to it. Lenders can seldom recall a loan when they foresee problems for the borrower. The default of mortgages led to the decline of the MBS and the CDOs while trading securities, on the other hand is simply buying and selling. There is of course always the danger that a bank’s inventory of securities will decline in value, but at least the banking entity has control over it at all times and can sell it quickly if it foresees adverse events in the future. 

 

Bank holding companies (BHCs) and the BHCs’ non-bank subsidiaries 

There are strong “firewalls” between Banks’ and their BHCs and non-bank affiliates. This being in place so that so that these firms cannot use the bank or its insured deposits for their own purposes. In the garb of trying to defend insured deposits, it actually severely restricts the legitimate and valuable activities of non-bank affiliates of Banks’. These restrictions will be very harmful to the financial system and hence the U.S. economy. 

 

 Undoing decades of innovations in Banking 

Banks’/Bankers being natural and knowledgeable participants are naturally advantaged to understand the direction of markets, interest rates, and events that influence both. By prohibiting this activity, the Volcker rule may inadvertently push banking activities back into a past. 

 

 Harder for companies to meet their cash 

Virtually all large companies in an economy now fund themselves by issuing securities like bonds, notes, and commercial paper and restrict resorting to borrowing from Banks’. Companies have found that issuing debt securities is more efficient than borrowing from a bank. 

The stock market is an example of a market where trading occurs and has a vast numbers of buyers and sellers as distinguished from a debt which is thinner though the debt market is much larger in dollar size. The major investors are mostly insurance companies and pension funds which buy debt securities to hold them to term and earn interest, not to trade them. In the event of a pension fund deciding that it wants to sell a debt security, it cannot readily find a buyer ready to bid as a participant in the stock market can do. The eventuality being taking a sharp cut in the value realized on the sale in case of a delay to find a buyer. This is where the Banks’ pitch in to alleviate such holders from their dilemma by acting as intermediaries as lubricate the market by buying bonds from sellers and selling them to buyers. Without them the “spread” between the bid and ask prices for the bond would be much wider, and that means it would cost firms more to buy a bond and they’d get a lower price when they sell it. If this becomes the regular pattern in the market for debt securities, it will be harder for companies to meet their cash needs by issuing these securities. 

 

 Basel – III 

Basel III not only redefines the qualitative and quantitative aspects of capital requirements but reduces leverage ratio through back stop leverage ratio, increases short term liquidity coverage and increases long term balance sheet funding. With the advent of LCR Banks’ will be required to hold substantial low yielding assets to meet the needs of short term liquidity. The raise in bench mark for both qualitative and quantitative aspect of capital may require Banks’ to raise capital. In 2009 10 out of 19 Banks’ failed the stress test and required a capitalization of approx USD 75 b. The introduction of LCR means that Banks’ need to invest on low yielding assets to meet their liquidity needs thereby compromising on profitability  .For meeting the needs of NSFR Banks’ need to find bulk corporate deposits worth maturity greater than a year  in a market with lesser appetite for term debt. This will increase cost of fund .To meet the needs of leverage ratio Banks’ may have to sell off low yielding qualifying assets thereby triggering the possibility of a downward spiral of prices. 

 

 

The scope of change required for compliance to the Dodd-Frank Wall Street Reform and Consumer Protection Act, and its impact on market participants is enormous involving precise and massive co-ordination within the organization across businesses and functions, operations and IT 

 

·         It is pertinent to identify opportunities so as to leveraging existing processes that can be reused and retooled 

·         Planning for the changes required with a holistic view of all new, on-going (Commitment to FRBNY, consolidation of accounting rules by IASB/FASB) and parallel (Basel III,ECB/ESMA) regulatory changes, but prioritized and grouped by criticality and cost-effectiveness 

·          Assessing the client value proposition emerging out from the shift of OTC derivatives to CCPs from a bilateral trading will be challenging. There will be enhanced cost on account of such switch. 

·         The defining of a new Target Operating Model (TOM) and effecting changes to people, process and technology so as to meet the execution of a business strategy transformation road map of projects is needed. This is a challenging proposition. 

·         So that the organization speaks the same language it is imperative to develop policies, processes, risks, controls and other key data elements so that they are common across. 

·         It is indeed an enormous task for Banks’ to understand the impact accruing out of 243 pieces of rule making with around 60 Studies and 170 Reports itself. Leave side the need to develop policies, processes, risks, controls and other key data elements so that they are common across. 

 

The Act has been heralded as the most significant in terms of scope and scale of change since the Glass Steagall act of 1932. It’s not only the Banks’’ but also their IT partners who have a huge task in front of them. Given the sheer magnitude and the complexities with rather conservative timelines it is important take a step back and look at the regulation in the context of international and other regulatory changes that are happening in parallel. It’s prudent to spend time in understanding the direct and indirect impact it could have on the technology landscape .The Banks’ always understood the challenge though their tone might have been seemingly ‘anti regulatory’ or ‘lobbyist’. The Fed has understood this and so have the law makers. At least the furore over the Feds announcement can also be reasonable.

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Banking practice Manager working mainly in Retail Banking and Risk Management -Basel,Dodd Frank,AML and FATCA and Regulatory reporting backed by Industry experience in wholesale and Retail banking

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