The Faculty Lounge

The Scylla and Charybdis of Central Hudson

I have said elsewhere ("A Necessary Cost of Freedom"?) that the Supreme Court's decision in Sorrell v. IMS Health may have, for all intents and purposes, done away with the Central Hudson test which any regulation relating to commercial speech must pass.  That test, for those unfamiliar with the doctrine (and really who is familiar with it outside of those litigating around it?), has 4 parts. The first two elements are almost never controversial. Prong 1 is whether the product or service is legal and whether the speech in question about that legal product or service is truthful and not misleading. (There is a wealth of complication here is this deceptively simple requirement but that is a post for another day. Suffice it to say that this is not usually where the fights are).  Prong 2 asks whether a substantial government interest is involved. Again, this is not usually the question around which a fight arises.

The fights usually arise around prongs 3 and 4. Prong 3 requires that the government show that its regulation "directly advance" the goal in prong 2 and Prong 4 requires that it does so without being "more extensive than necessary" to advance that goal in prong 2.

As we look at the many public health issues - off label use marketing, junk food marketing and others - you might notice a problem.  Regulatory efforts which are effective are likely to be fairly broad - say banning certain types of advertising altogether or banning in particular venues and thus will very often run afoul of prong 4.  In contrast, when agencies or legislators try to very narrowly tailor a particular rule, chances seem very good that it will be harder and harder to measure effectiveness or to attribute any change to a particular measure so narrowly tailored provisions may fail prong 3.  This last observation may be exacerbated by courts willingness to interpret the standards for the admissibility of expert evidence under Daubert to require unrealistic standards for causation or, at the very least, to give an advantage to those entities able to marshal a great deal of evidence to cast doubt on a particular claim. The Most Influential Supreme Court Decision You've Never Heard Of.

This may be only one of many reasons not to mourn the potential irrelevance of Central Hudson, although I caution that nominally it is still good law and the Court took pains not to overrule it.  But many an effective intervention could easily get crushed between the jaws of prongs 3 and 4, particualrly in the current environment where courts seem inclined to treat claims for freedom for commercial speech so generously. That is probably bad news for the public health community and perhaps for the regulation of the marketing practices of the financial industry. 

Free speech and the rating agencies

Now that the United States has sued Standard and Poor's over the subprime mortgage fiasco, see The S&P Lawsuit, it will be interesting to see whether S & P will raise a First Amendment defense as it has in some of the civil cases.  Some observers say that the courts are likely to give it a chilly reception. S&P Lawsuit First Amendment Defense May Fare Poorly, Experts Say. I am inclined to agree, although not because the case law wouldn't permit the courts to consider this defense. Rather, I suspect the implications for permitting the rating agency's opinions to be treated like fully protected opinions and subjected to a New York Times v. Sullivan standard, a standard under which a certain amount of falsity is protected as a necessary evil so that we can protect the speech that we value, would have intolerable implications for 10(b)5 and maybe fraud cases generally. 

Ella . . . Ella

 

As I mentioned in my prior post, I spoke on Monday about “rogue trading” at a seminar hosted by the Autorregulador del Mercado del Valores de Colombia in Bogotá, Colombia.  Though this is a topic I’ve discussed before at risk management meetings and seminars, this was the first time that I’ve had sufficient information regarding the Kweku Adoboli case to include him as a part of my presentation.  As I’ve discussed before, Adoboli is the alleged UBS rogue trader currently standing trial in the UK on criminal charges stemming from unauthorized trading that first came to light in September 2011.

I should say at the outset that there are still a lot of open questions concerning the Adoboli case.  UBS has conducted (and, I believe, completed) an internal investigation and KPMG has an ongoing external investigation.  UK (FSA) and Swiss (Finma) authorities also have initiated enforcement actions, which are still in progress.  So most of what we know about the case comes from press reports regarding the trial testimony and evidence, including testimony from UBS employees and internal auditors regarding the UBS and KPMG investigations.

What we do know is that Adoboli was a trader on UBS’s four person ETF desk.  According to Adoboli, he began off-books trading in 2008 using an account nicknamed “umbrella,” which he used as a slush fund to hide profits until he needed them to cover a loss on some later, rainier, day.  As I’ll discuss in another post, such smoothing of profits and losses is a common element in other recent rogue trading cases, including Jerome Kerviel at Société Générale.

The umbrella account is the one element of the case that has finally convinced me of the possibility of an Adoboli made-for-television movie (note to networks: I’m willing to consult on the cheap in exchange for hobnobbing with movie stars . . . or just for free lodging).  I think that we’re due for another rogue trading movie.  Though Nick Leeson got a real (not TV) movie out of his ordeal -- starring Ewan McGregor, no less -- it was a real dud, which hasn’t prevented me from showing it in class about a dozen times. 

But the umbrella account has, perhaps surprisingly and most definitely entertainingly, turned out to be an important element of Adoboli’s defense.  Adoboli’s lawyer, Charles Sherrard argues that all three ETF desk traders, including Adoboli’s supervisor, John Hughes, knew about the umbrella account.  Sherrard has introduced numerous email and chat communications referencing Adoboli’s “umbrella,” “Rhianna,” and “ella ella,” in an attempt to establish that Adoboli, far from being a rogue agent, was part of a collaborative scheme in which other bank employees (again, including his direct supervisor) acquiesced. 

  Even the UBS internal investigation concluded that “there is strong evidence of collusion at local desk level,” and that the “local supervisor was aware of Mr Adoboli’s propensity to smooth the profit and loss and take unacceptably high levels of net delta [risk]”.   The traders who have testified (including Hughes) have mostly admitted their knowledge of the umbrella account, but claim to have misunderstood its purpose. 

 I’ll be back later with more to say about Adoboli and UBS, and how the facts compare to other major rogue trading incidents.  

In the meantime, make sure to watch the Rhianna video above – ella, ella comes at around 1:35.

Photo: view of Monserrate from the Fernando Botero museum, Bogotá, Colombia.

Prior related posts:

AMV Seminario De Control Interno Y Compliance: Bogotá, Colombia

Kweku Adoboli Trial Began Today

The Rogue Trading KISS

When $61bn Seemed Like Real Money

Denial: It Ain’t Just A River In Egypt

It’s The Stupid Culture

It’s The Culture, Stupid

Kerviel’s Fake Trades: Genius Or Copy Cat?

Kerviel’s Fake Trades: The Anatomy of A Cover-Up

On Warning Signs II: Follow The Money

On Warning Signs: You Can’t Get There From Here

Rogues Versus Scapegoats

Kerviel Trial Opens to Fanfare

Société Générale: Back In The Saddle Again

Jérôme Kerviel to Société Générale: Stand By Your Man

 

AMV Seminario De Control Interno Y Compliance: Bogotá, Colombia

As some of you may have been able to guess from the photos I posted yesterday, I was in Bogotá, Colombia this past weekend as a guest of the Autorregulador del Mercado del Valores de Colombia to speak at their III Seminario De Control Interno Y Compliance: Experiencias Y Mejores Prácticas En Los Mercados De Activos Financieros. 

This was really a fabulous program – well organized, with excellent simultaneous translation and interesting speakers (the list is below).  Special thanks are due to Ana María Prieto Ariza, Subdirectora de Divisas, for taking such good care of the foreign speakers, and to AMV President Roberto Borrás Polanía for hosting us. 

The conference was a particularly interesting mix of different geographical and subject matter areas of expertise – US, Colombian, and Mexican and legal, accounting, and risk management, in particular. Such a combination always presents the danger that people will talk past each other, but I didn’t find that to be the case here.  In fact, as we speakers discussed among ourselves at lunch and dinner, we were all pleasantly surprised at the numerous points of commonality across our presentations, and by how much we still had to share with each other after the formal conference concluded. 

I was at the seminar to talk about “rogue trading” – a topic I also discussed at last year’s Risk Management Association annual Governance, Compliance and Operational Risk Conference in Cambridge.  This year, however, I spent a good chunk of the presentation discussing the ongoing criminal trial of Kweku Adoboli, the alleged UBS rogue trader accused last year of losing $2.3 billion.  On Friday, the court added two additional false accounting charges.  Adoboli thus now stands accused of four counts of false accounting and two counts of fraud by abuse of position.

I’ll return shortly to talk some more about various elements of the trial and, in particular, the differences and similarities between the Adoboli case and other recent rogue trading incidents.  

 

Speakers List:

* Gerardo Hernández Correa, Superintendente Financiero de Colombia

* Roberto Borrás Polanía, Presidente, Autorregulador del Mercado de Valores de Colombia (AMV) 

* Leonardo Villar Gómez, Director Ejecutivo, Fedesarrollo

* Muna D. Buchahin, Vicepresidenta, Asociación de Examinadores de Fraude Certificados (ACFE), México

* Kimberly D. Krawiec, Professor of Law - Duke Law School, North Carolina

* Rosemary Hollinger, Asesor regional, Commodity Future Trading Commision (CFTC), Chicago 

* Arnulfo Vanegas Montenegro, Director de Supervisión, Autorregulador del Mercado de Valores de Colombia (AMV)

* Álvaro Tirado Quintero, Presidente, Interbolsa

* Diego Jiménez Posada, Presidente, Correval

* Alonso Ángel Lozano, Vicepresidente de Inversión, Porvenir 

 

Photo top right: Funeral mask, El Museo del Oro

Photo middle left: building in La Candelaria

Call for Articles: Arkansas Law Review

From my friend (and Arkansas law professor) Dustin Buehler:

The Arkansas Law Review is pleased to announce a call for papers in conjunction with the 2012 Annual Symposium to be held on Friday, November 9 in Fayetteville, Arkansas.  The topic of the symposium will focus on the mortgage foreclosure crisis.  The University of Arkansas School of Law is delighted to host Professor Dale Whitman as a Visiting Professor for the 2012-2013 academic year.  His scholarship has informed the direction of our symposium.

The first issue of Volume 66 will be devoted to the Symposium and will be published in early spring 2013. We encourage articles analyzing both the causes and effects of the crisis from a regulatory perspective and a homeowner perspective.  We would also appreciate forward-looking articles that posit solutions and preventive measures.    

Authors should submit an abstract and a cover letter to [email protected].  The deadline for submissions of article proposals is Monday, October 8, 2012.  Please feel free to email Robin Wright at [email protected] with any questions.

CFP: Securities Regulation and Financial Institutions

Call for Papers

AALS Joint Program of the Securities Regulation Section and

Financial Institutions & Consumer Financial Services Section

The Regulation of Financial Market Intermediaries:

The Making and Un-Making of Markets

AALS Annual Meeting, January 4, 2013

New Orleans

 

The AALS Section on Securities Regulation and the Section of Financial Institutions & Consumer Financial Services are pleased to announce that they are sponsoring a Call for Papers for their joint program on Friday, January 4^th at the AALS 2013 Annual Meeting in New Orleans, Louisiana. 

The topic of the program and call for papers is “The Regulation of Financial Market Intermediaries: The Making and Un-Making of Markets.”  The financial crisis witnessed numerous market failures involving an array of financial market intermediaries, including banks, broker dealers, and various kinds of investment funds (from money market mutual funds to hedge funds).  The crisis came at the end of a decades-long transformation of the U.S. financial services sector that blurred the boundaries between banking and securities businesses.   During this period a range of new intermediaries emerged and connected individuals and firms seeking financing to investors in capital markets.  At the same time, capital markets became increasingly dominated by financial institutions and other institutional investors.  Intermediaries devised and “made markets” for new and often highly illiquid and opaque financial instruments.  Many of these new markets froze or crashed in the financial crisis.  In response, Dodd-Frank and other financial reforms have imposed a grab bag of new rules on financial intermediaries. 

Yet the effects of these financial reforms remain unclear.  Moreover, policymakers and scholars often disagree about the precise problems that these reforms are meant to address.  For example, the SEC’s headline-grabbing suit against Goldman Sachs over the ABACUS transactions focused on conflicts of interest for large financial conglomerates with different stakes in a transaction.  Meanwhile, other financial reforms have focused on the opacity of pricing in financial markets or on the solvency or liquidity risk faced by intermediaries.

The tangle of potential market failures has led to a range of policy responses.  Often banking and securities scholars seem to look at the same set of market practices through radically different lenses.  Banking scholars focus on solvency crises and banking runs and debate the application of prudential rules on the risk-taking, leverage, and liquidity of intermediaries.  At the same time, securities scholars emphasize the problems of conflicts of interest and asymmetric information.  They then look to the traditional policy tools in their field such as disclosure, fiduciary duties, and corporate governance. 

The dearth of dialogue between these two fields creates the risk of confusion in identifying both problems and solutions for financial intermediaries and the markets in which they operate.  To move the discussion forward, scholars in both fields may have to move outside their comfort zones.  The study of financial institutions cannot be limited to deposit-taking banks.  Similarly, securities regulation involves more than securities offerings and litigation, but the regulation of broker-dealers, investment advisers and funds, and the regulation of trading and markets.      

Form and length of submission

The submissions committee looks forward to reviewing any papers that address the foregoing topics.  Abstracts should be comprehensive enough to allow the review committee to meaningfully evaluate the aims and likely content of papers they propose.  Eligible law faculty  are invited to submit manuscripts or abstracts dealing with any aspect of the foregoing topics. Untenured faculty members are particularly encouraged to submit manuscripts or abstracts.  

The initial review of the papers will be blind.  Accordingly the author should submit a cover letter with the paper.  However, the paper itself, including the title page and footnotes must not contain any references identifying the author or the author’s school.  The submitting author is responsible for taking any steps necessary to redact self-identifying text or footnotes. 

Papers may be accepted for publication but must not be published prior to the Annual Meeting.

Deadline and submission method

To be considered, papers must be submitted electronically to Erik Gerding at [email protected].  The deadline for submission is August 10, 2012. 

Papers will be selected after review by members of a Committee appointed by the Chairs of the two sections.  The authors of the selected papers will be notified by September 30, 2012. 

The Call for Paper participants will be responsible for paying their annual meeting registration fee and travel expenses.

Eligibility

Full-time faculty members of AALS member law schools are eligible to submit papers.  The following are ineligible to submit: foreign, visiting (without a full-time position at an AALS member law school) and adjunct faculty members, graduate students, fellows, non-law school faculty, and faculty at fee-paid non-member schools. 

 

Please forward this Call for Papers to any eligible faculty who might be interested. 

 

 

Dodd Frank Rulemaking Snapshot

Via Alphaville comes this snapshot, courtesy of Davis Polk, of Dodd Frank rulemaking progress (or lack thereof, depending on whether you’re a glass half full or half empty type of person).  The full Davis Polk Dodd Frank progress report is here.  

Zaring On Regulatory Competition And The Financial Crisis

David Zaring discusses at RegBlog:

One question posed by the recent financial crisis was whether our confusing and disaggregated approach to financial regulation in the United States was to blame for the downturn.  Did our regulators fail to identify weaknesses in the financial intermediaries they oversaw that they should have seen? 

Dain Donelson and I attempted to answer part of this question by studying the performance of the Office of Thrift Supervision (OTS) during the crisis. OTS was the smallest federal banking regulator, the one most criticized by Congress for its performance, and the only agency sanctioned in the Dodd-Frank Act: it was eliminated, and its functions were moved elsewhere in the Treasury Department. Our research examined a particularly disparaging criticism of OTS: did this agency offer banks soft touch regulation as a way of competing for supervision fees against more rigorous regulators?

We did not find much evidence in support of this oft-proffered view. 

Read the whole thing here.

 

JP Morgan's Whale-sized Lobbying

As I mentioned the other day, one of the reasons that the press, pundits, and politicians are taking such pleasure in bashing JP Morgan on its trading losses is because Jamie Dimon has been one of the most vocal critics of the Volcker rule and other financial reforms, insisting that they’re unnecessary and so costly as to make American banks uncompetitive. 

And JP Morgan has also been one of the (if not the) most active institutions lobbying federal regulators for favorable Volcker rule interpretations and exemptions.  For example, in the period between Dodd-Frank signing and proposed rule publication, JPMC met with federal regulators charged with Volcker rule implementation, either alone or with other industry members, a total of 27 times – more than any other single entity, organization, or person.  (Table 8 at right shows this information, this paper has more details.)

This meeting activity continued after rule proposal, though the rate appears on first cut to have declined.  I’ll have more detailed information on that down the road, as my RAs and I finish going through the meeting logs beginning the day after the Volcker rule proposal.  JPMC also filed a substantial (65 page, not counting the appendix) comment letter complaining that the proposed Volcker rule was too restrictive and went beyond Congress's wishes as expressed in the statute, and outlining its suggestions for appropriate revisions. 

Although it can sometimes be difficult to get an accurate sense of meeting content from logs, the Federal Reserve’s are pretty good and give at least some indication of the points being discussed.  Those logs show that JP Morgan met with fed staff to argue that the proposed Volcker rule needed more narrow definitions of prohibited activity and more broadly defined exemptions, that the rule as proposed would negatively impact their own business and markets generally, and would render US banking entities uncompetitive.  On the substance, the logs show that JPMC discussed with fed officials both the proprietary trading and fund investment restrictions of the Volcker rule, as well as concerns regarding the effective date, the conformance period, the use of specific metrics to gauge Volcker rule compliance, and the hedging, market making, underwriting, and customer service exemptions of the rule, among other items. 

I should be circulating a draft of a new paper by the end of the summer that details these meeting logs and comment letters more systematically, and places them in the context of rule changes from inception to final product (whenever we finally have one).  But even from the limited preview here, you can, I think, see why reform-minded commentators are taking particular pleasure in this JP Morgan misstep.  

 

Follow @KimKrawiec

JP Morgan Updates

Jamie Dimon called to testify before the Senate Banking Committee next month. BLT

Securities Suit Filed Against JP Morgan Chase Over Trading Losses. Professor Bainbridge

The unit at the centre of JPMorgan Chase’s $2bn trading loss has built up positions totaling more than $100bn in asset-backed securities and structured products. FT

And Tracy Alloway, Felix Salmon, and Lisa Pollack all have more information on the exact nature of the JP Morgan whale trades.  

Putting the JP Morgan Loss In (Real) Perspective

Ever since JP Morgan’s announcement of a $2 billion loss on Thursday from what might or might not be a hedging transaction, advocates for financial reform have used the news as a basis for calls to strengthen rules currently in the works, most notably the Volcker rule.  This is not the least bit surprising, given both the nature of politics and the fact that Jamie Dimon has been the most vocal opponent of such reforms, insisting that they’re unnecessary and so costly as to make American banks uncompetitive.  So it’s really a given that reformers and pundits are not going to waste an opportunity to hit back when Mr. Dimon announces losses from egregious sloppiness that are multiple times his own estimates of the costs of Volcker rule compliance. 

Perhaps just as predictably, less reform-minded commentators are now fighting back.  Notably, Jonathan Macey has a piece in today’s WSJ arguing that we should keep the JP Morgan losses in perspective.  Says Macey:

The truth is that nobody should care about J.P. Morgan's loss—nobody except J.P. Morgan stockholders and a few top executives and traders who will lose their bonuses or their jobs in the wake of this teapot tempest. The three executives with the closest ties to the losses are already out the door.

After the $2 billion in losses, J.P. Morgan still had $127 billion in equity. This means that J.P. Morgan could lose another $100 billion and creditors would still have an equity cushion that could absorb 10 times the losses that the bank suffered on this trade. . . .

Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan's losses should be treated as further proof that markets work. J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.

Yes, of course the losses are small change given JP Morgan’s size and, of course, politicians are opportunists.  Moreover, I’ll even grant Macey’s basic position that markets typically work better than governments.  More to the point, I’ve been quite vocal on this blog about the limitations of the Volcker rule, along with many other Dodd Frank reforms.

But, this “let’s put the JP Morgan loss in perspective” tale making its rounds the past few days quite misstates both the concerns of the proposed Volcker rule and what is worrying about the JP Morgan losses.  The rationale behind the Volcker rule became embodied in a “too big to fail” and “no government bailouts” narrative, perhaps because those were winning spin points for Obama and because those rationales are easier for the general public to grasp.  But the real rationale of the rule was really about subsidies: depository institutions receive a variety of federal subsidies, including underpriced federal deposit insurance and liquidity assistance.  The sense of most Volcker rule proponents (or at least the more thoughtful ones) is that these federal subsidies, designed to provide stability to such institutions, should not then be leveraged into risky trading activities that bear no relation to traditional banking services.  I’ve discussed my own views on this before: the Volcker rule’s goals are noble in theory, but I’m not persuaded the rule will be at all workable.  And, as I discussed in this earlier post, the JP Morgan loss – rather than illustrating the need for the Volcker rule -- demonstrates the many hurdles to successful implementation. 

But we should be straight about the purposes of the rule. 

Yes, markets typically work.  Maybe if we allowed them to work for banking entities we wouldn’t need to worry about JP Morgan’s risk profile.  But we don’t . . . so we do.  

Quacking Like A Prop Trade

So, I’ve finally gotten out from behind the wheel of a car long enough to post something a bit meatier on the JP Morgan Whale Fail.  As I predicted in my earlier post, the case is already generating much debate about the implications for the Volcker rule, and could conceivably impact the rule’s final content. 

Jamie Dimon claimed in a conference call on Thursday afternoon that the trade, while flawed, was consistent with the Volcker rule’s proposed hedging exemption.  I wonder whether that’s really the best rhetorical tack to take.  If true, it will simply lead to calls for a stricter final rule, or renew calls for more drastic solutions, such as breaking up large, systemically important institutions. 

For example, Sheila Bair is calling for a more narrow definition of the hedging exemption to the Volcker rule, and Barney Frank (who has to be one of the funniest guys on the hill) quipped that, though Jamie Dimon has spent months complaining about the $400 million that financial reform compliance will cost JP Morgan, the firm managed to lose five times that amount in a matter of weeks “entirely without any help from the government.”

In dispute is whether or not the Whale’s positions, about which few details are known at this point, was a hedge, which would be permitted by the Volcker rule, or a proprietary trade, which would not be. Dimon’s position is that the trade was simply a poorly-designed hedge gone awry -- people make mistakes, people made them here. 

I’m skeptical of that explanation, though it could turn out to be true.  Lisa Pollack at FT Alphaville has done a great job of speculating about the nature of the trades, based on a variety of public documents and statements.  It’s a very complicated story and I won’t try to replicate it here, but you can head over to Alphaville if you’re interested in the nitty gritty.  In brief, her theory is that JP Morgan was betting that the CDX.NA.IG.9 — a credit index that was launched in 2007 — would flatten.

There seem to me to be a couple of different possibilities here.  One is that, as claimed by Dimon, the position started out as a hedge against JP Morgan’s credit exposure.  Perhaps, though intended as a pure hedge, the design of the hedge was flawed from the start.  Or perhaps the “hedge” had a bit of a directional bet built into the design.  Notice that scenario one would appear to comport with the spirit of the Volcker rule, whereas scenario two does not.

However, Dimon’s contention appears to be that the error (assuming there was one) arose later, in connection with rebalancing the hedge:

The original premise of the synthetic credit exposure was to hedge the company in a stress credit environment. Our largest exposure is credit across all forms of credit. So we do look at the fat tails that would affect this company. That was the original proposition for this portfolio.

In re-hedging the portfolio, I've already said, it was a bad strategy. It was badly executed. It became more complex. It was poorly monitored.

So that brings up two other scenarios: one, the rebalancing, while intended to maintain a pure hedging position, was flawed; or two, the rebalancing was purposely off-kilter a bit, in order to take a directional position.  Again, I’d think that one scenario meets the spirit of the Volcker rule and the other does not. 

All of this to me simply highlights the difficulties confronting effective Volcker rule implementation and enforcement, about which I’ve written here on many occasions.  Poorly constructed hedges may quack like a prop bet, but in order to effectively address the concerns underlying the Volcker rule, and other Dodd Frank reforms, regulators will have to be able to tell the difference before the firm announces a $2 billion loss.  

 

JP Morgan’s Whale

This will have to be a quick one today, but JP Morgan’s “whale fail” is going to make for some interesting news over the coming weeks.  The timing couldn’t be worse for JP Morgan and the industry generally, it seems to me.  Embattled over the Volcker rule, capital requirements, and numerous other issues, this is exactly the type of event that will lead reformers to call for a crack down, just as regulators are contemplating the final content of some important pieces of financial reform.  I’ll be back in the near future with more on this story and the implications for the Volcker rule, in particular.  In the meantime, news stories are in the WSJ, Forbes, and the FT, among others.  

As I’ve mentioned before, I’m spending quite a bit of time with the Volcker rule these days, and I’m especially interested in the implications of this news for the continuing manuevering over the final content of the rule.  According to news reports, the losses originated with the credit desk in the London unit of JP Morgan’s chief investment office, which the bank says “hedges positions and invests ‘excess deposits’.”  As more information on the exact nature of the trades emerges, I suspect the case will present a beautiful example of the hurdles to Volcker rule implementation – namely, differentiating from a regulatory perspective trades permitted by the hedging and other statutory exemptions from prohibited proprietary trading.  Surely it will impact the discourse surrounding the rule.

Back with more later . . . 

 

 

The Volcker Rule: Short ≠ Simple

A recent post by my friend Steve Bainbridge reminds me that I’ve been meaning to weigh in on the most recent in a long line of controversies surrounding the Volcker rule, whose provisions are scheduled to be implemented on July 21, 2012. Almost no one believes that the federal agencies will have finalized the necessary rules prior to that time, which has generated a rush of accusations, panic, and grand standing. 

For example, Barney Frank has called on regulators to simplify and finalize the Volcker rule prior to Labor Day.  SEC commissioner Troy Paredes and former FDIC Chairman Sheila Bair have argued that the rule is so complicated that agencies should repropose it and start all over again.  And a bipartisan group of senators has offered a bill that would relieve financial firms from compliance with the Volcker rule until one year after regulators have finalized their rules.

I’m largely on board with Steve’s general analysis of the rule, but I want to push back against his contention that regulators have taken Congress’s simple ban and turned it into an unworkable monstrosity at the behest of relentless industry lobbying.  This charge has been taken up by a number of sources lately (see here and here), including by some self-serving members of Congress.

Let’s get one thing straight: Congress did not enact a simple rule – it enacted a short rule.  By definition, a rule that purports to ban proprietary trading while maintaining an active role for banks as financial market intermediaries, including as market makers, is not a simple rule. 

Yes, the Volcker rule is a complex muddle and the costs may not be worth the benefits – as I discuss in some detail here, the Volcker rule is perfectly laudable in concept but presents many implementation and enforcement challenges.  And, as I’ve documented at length, industry lobbying of agencies charged with Volcker implementation has been both persistent and extensive since the day Obama signed the legislation, if not before. 

But, both of these results were predictable, indeed virtually inevitable, given the original statute.  Moreover, this sort of blame shifting onto unelected officials is exactly what I’ve been predicting ever since Dodd-Frank passage.

Just because you’re short doesn’t mean you’re cute.  It doesn’t mean you’re simple either.

Update: Steve argues that I misinterpreted his original post:

(1) My reference to the "original Volcker rule" linked back to a post discussing Paul Volcker's original suggestion, not the version incorporated into Dodd-Frank. (2) I noted that "the process of turning the simple original proposal into law has turned into a classic example of legislative and regulatory sausage making." I thus had no intention of complimenting Congress for its work in Dodd-Frank. To the contrary, I intended to suggest that both Congress and the regulators were at fault. Indeed, I've agreed all along with Kim's observation that the regulatory mess was "predictable, indeed virtually inevitable, given the original statute."

My apologies to Steve for misunderstanding his original post, and for lumping him in with others who have made the "blame the regulators" argument.  I'm not so sure that Volcker’s original “I know it when I see it” approach to prop trading would have been all that workable in practice, either, but that’s a post for another day.  

 

Central Clearing of OTC Derivatives -- Protecting Customer Contracts and Collateral

One of my financial derivatives students – Shinichi Yoshiya – has posted to SSRN a very informative paper on the choice among collateral protection regimes as the swaps market moves to central clearing.  The paper analyzes the pros and cons of five margin protection models (Baseline Model, Physical Segregation Model, Complete Legal Segregation Model, Legal Segregation with Recourse Model, and Optional Model) based on their ability to achieve the underlying rationales of the Dodd-Frank Act.

If you’re looking for a concise discussion of the CFTC’s options regarding the treatment of customer margin in centrally cleared swaps, you can start here.  The CFTC adopted the LSOC model after the paper was completed, but, in light of the MF Global incident, some have expressed reservations about the model.  (See, for example, this discussion). 

As a bit of background, prior to coming to Duke for an LL.M., Shin spent six years at Deutsche Bank, Shinsei Bank, and Morgan Stanley (all in Tokyo).  At Deutsche, Shin represented the firm on the ISDA determinations committee and documentation committee and at Shinsei he worked on credit events for Lehman, Fannie, Freddie, and WaMu, among other duties. 

On March 1 2012, the CFTC hosted a round table on this topic, available here.

 

Volcker Rule Duels and Meanings

Over at the Conglomerate, David Zaring has a nice post on the dueling commentaries surrounding the Volcker rule.  Some sources insist that the rule is useless due to hopeless complexity and vagueness.  Others contend that the rule seriously hampers banks’ bottom line.  Indeed, many banking industry members contend that the Volcker rule, unless narrowly interpreted and enforced, threatens the viability, not only of banking entities, but also of trading markets more generally.  David correctly highlights one of the impediments to any real understanding of the trade-offs confronting regulators on Volcker rule implementation – the issues are so complex and numerous, and the rhetoric has become so overblown, that it’s difficult to get any real sense of the challenges confronting rule implementation and enforcement. 

But I think David misses the mark when he points to structural changes at banks as evidence of the Volcker rule’s effectiveness: 

And all the indicia, literally all of them - that investment banks are losing money, planning layoffs, and spinning off prop trading at the same time - suggest that regulatory reform, rather than being ignored, is substantially affecting the organization of financial intermediaries. 

But a rule that merely affects financial intermediary organizational structure is not the same thing as a rule that successfully inhibits prop trading.  As I discuss at length here, in anticipation of the Volcker rule, a number of affected banking entities have shut down or announced an intention to shut down their stand-alone proprietary trading desks.  According to news reports, some of those traders have been relocated to other parts of firms’ trading operations.             

The key point here is that stand-alone proprietary trading activity accounts for a relatively small amount of banking entity revenues, probably around three percent. To avoid an easy end-run around the Volcker rule’s restrictions, federal regulators will have to police trading that takes place outside of designated proprietary trading desks -- for example, trading in connection with market making, underwriting, hedging, and customer service. In other words, the battle lines are not over prop trading desks.  What matters is how federal agencies will ultimately define the exemptions to the proprietary trading ban, and then police trading activity to distinguish permitted trades that constitute market making or trading on behalf of customers from prohibited proprietary trading activity.

In addition, Steven Davidoff’s contention that the Volcker Rule “may have the unintended effect of dividing the world back into investment banks and commercial banks” is, in my view, mistaken.  This roundabout return to Glass-Steagall was precisely the intention of many Volcker rule adherents, including, according to some sources, Paul Volcker himself.  (A point I discuss here).  Whether that result is good or bad is, of course, open to much debate.  But it’s hard to claim this potential result was unforeseen.

Volcker Deadline Tomorrow

From the FT:

Some 1,400 questions. A total of 298 pages. One proposal.

Monday is the deadline for financial market participants to submit final responses to the Volcker rule, the eponymous legislation aimed at banning speculative trading at commercial banks. The authorities can expect a deluge of feedback.

Responses are expected to run to hundreds of pages, creating a mountain of electronic paperwork. Big Wall Street groups are putting the finishing touches to their own submissions, polishing their arguments with an analytical rigour that was missing in the years before the financial crisis. Banking lawyers and risk officers will be spending the weekend poring over comment letters in an effort to convince regulatory authorities to tweak the rules.

They’re not the only ones, though it will take me considerably more time than the weekend.  As I’ve discussed here before (see Erik Gerding’s helpful gathering of the complete set of posts for an on-line symposium on this topic), I’ve spent a good chunk of time this year analyzing the 8000 comments on the Volcker Rule solicited by FSOC in advance of their statutorily-required study, as well as the meeting logs of the five federal agencies charged with Volcker Rule implementation. (You can find that paper here) 

Last week, I began a preliminary look into the comments received during the notice and comment period after the Fed, FDIC, OCC, and SEC (and, later, CFTC) NPRM, even though the comment period had not yet closed.  Just a few preliminary thoughts on that, which of course may need revising after all of the comments are in and I've had a chance to more systematically examine them. 

There appear to be far fewer comments during this period than during the FSOC comment period.  In particular, there is less activity from the general public.  At the same time, my initial impression is that these comments are more lengthy and detailed, and are more substantive (including those received from members of the general public) than those received during the initial comment period.  I suspect this reflects a change in strategy by relevant Public Interest Groups, about which I will have more to say later. 

One final item of interest that I have noticed is the number of criticisms of the regulatory and notice and comment process itself from some comment letters.  For example, I have seen complaints that the proposed rule is too long and asks too many questions, that only financial industry members could reasonably be expected to invest the time and resources to understand and meaningfully comment on the rule, leading to one-sided input, and that interest groups have already had enough opportunity to influence the outcome of the rule and should not be afforded any more.  Some of these letters are critical of financial industry efforts to influence Volcker rule implementation, and are quite well drafted. 

I’ll be back with more details, as I continue to go through the comments and meeting logs and wait – along with everyone else – for final rules.

 

Bradley on Krawiec on Dodd Frank on Jotwell

Caroline Bradley of the University of Miami School of Law (who also blogs at blenderlaw) has just posted a discussion of Kim Krawiec's "Don’t 'Screw Joe the Plummer': The Sausage-Making of Financial Reform"  at jotwell.  Bradley begins her discussion:

Much recent scholarship on financial regulatory reform since the global financial crisis critiques the substance of new standards and rules. For this paper ... Kimberly Krawiec chose to examine the process which produces rules of financial regulation (this is the sausage-making of the paper’s title). The current administration, like governments of other countries, has emphasized the importance of transparency and open government and of opening up decision-making to citizen participation, so an academic study like this paper, which examines citizen participation in rule-making, is timely and important.

The paper’s case study is of the Volcker rule, which restricts proprietary trading and ownership interests in hedge funds and private equity funds by banking entities. Professor Krawiec chose to focus on the Volcker rule because it “had the potential to illuminate questions of whose voice gets heard on a major issue of financial reform as the sausage is really getting made.”  The Dodd-Frank Act left significant discretion to regulators with respect to the details of this rule (and others): key terms and the contours of the exceptions to the bans are not clearly defined. Professor Krawiec explains that the exceptions were a necessary component of a compromise between those who thought that Dodd-Frank should do more to rein in large financial institutions and those who were sympathetic to complaints from financial institutions.  She also points out that much of the trading the Volcker rule explicitly permits shares objective characteristics with proprietary trading, such that the motive for the trading is the distinguishing characteristic.

Read the rest of her analysis here.  You may recall that Kim blogged about the reseach on this last fall here.  And the Huffington Post discussed the paper here.

Friðrik Már Baldursson on “Iceland’s programme with the IMF 2008–11”

During the global crisis, Iceland was hit by the biggest banking crisis any country has ever suffered. Over at VOX, Friðrik Már Baldursson reviews the role of the IMF in Iceland’s recovery.  He argues that the IMF program, though not perfectly designed, was successful -- Iceland re-entered the capital markets less than three years after the crisis.

I’ve blogged about Friðrik here at the Lounge before: he is the dean of the school of business at Reykjavik University and was my host during a recent trip to Iceland to discuss banking reform and the political process.

Why Iceland Should Be Your New Favorite Place

So, I promised more details on the setting for the beautiful waterfall photo that I posted yesterday.  I was in Iceland, giving a talk at Reykjavik University, and some of you recognized the location as Gullfoss.  This was my first trip to Iceland and it was spectacular!  Icelanders are some of the warmest people you’d ever want to meet (their climate less so – remember, I’m southern) and the country is beautiful.

My incredibly gracious hosts for the trip were Ragnhildur Helgadóttir, Professor of law, and Friðrik Már Baldursson, dean of the school of business.  Ragnhildur is a UVA alum, having done both her LLM and SJD there, and is the author of several recent books, including, Almannatryggingar og félagsleg aðstoð [Social Security Law] (with Guðmundur Sigurðsson) and The Influence of American Theories on Judicial Review in Nordic Constitutional Law.

 And Friðrik, in addition to being about the nicest, most unassuming person in the world, is also the only business school dean I’ve ever met who is also a statistician and mathematician.  Friðrik was formerly a faculty member at Columbia’s statistics department, before making his way to the econ departments and business schools at University of Iceland and then Reykjavik.  His research involves energy and environmental issues, among other things.     

I was quite excited to present this paper to an Icelandic audience.  The topic was public involvement in banking reform issues and, as most Lounge readers already know, Iceland was faced with a banking crisis that garnered international attention – and litigation – a few years ago.  For those who don’t remember the crisis, or never followed it, NPR Planet Money had several podcasts that are a great introduction to some of the issues.  I would link to them here, had I not given up after 20 minutes of vainly searching for them [Note to NPR: work on that podcast search feature.]

One of the most striking aspects of the dispute, to me, was the use of public referenda (two, I believe) on Icesave.  So, I assumed that my Icelandic audience would have quite different views about public involvement in financial issues than a US audience might.  But, that turned out not to be the case, I think. 

One of the things we discussed (and that I address in the paper) was the tension between the ideal of public involvement as a check on special interest capture of the political process, and the general inability of the public to understand – or even care about – these issues enough to act as an effective check that goes beyond “banks are greedy.”  

And a very refreshing aspect of the Reykjavik workshop culture is that the local community is invited to, and attends, faculty workshops.  So members of the local business bar (particularly banking specialists), the press, and the local business community were at the workshop and participated in the Q&A.  It was especially nice to have this discussion that cut across, not only national boundaries, but professional ones as well.

Like Roger, just a whole bunch of reasons to make Iceland my new favorite place.