Are We There Yet? Driving The Financial Reform Bill Home
This morning, at 5:39am, a conference committee comprised of 43 lawmakers from the House and the Senate agreed upon a final version of the financial reform bill. The bill is expected to pass in both chambers of Congress and to be signed into law on July 4th by President Obama. As anticipated, the final version reflects critical compromises that may alter the bill’s ability to mitigate the systemic risk in the financial system that inspired the bill’s creation.
Earlier versions of the bill included provisions proposed by former Federal Reserve Chairman Paul Volcker and Senator Blanche Lincoln. These provisions aimed to prohibit federally insured banks from engaging in riskier investment activities, such as investments in hedge funds or private equity funds, and required banks to limit and isolate their proprietary trading activities and to discontinue their origination and trading of nontraditional or exotic investment products, such as derivatives contracts. In the face of strong and well-financed opposition, the conference committee has adopted a less restrictive version of the proposed regulation.
In the version of the bill adopted by the conference committee, in lieu of a ban on alternative investments, banks retain the right to engage in hedge fund and private equity fund investments subject to a cap limiting those investments to 3% of the funds’ capital and no more than 3% of the banks’ tangible capital. The shift from a ban to a limitation on alternative investments curtails the bill’s impact in two significant ways: the cap continues to allow federally insured banks to have exposure to assets that perform with less predictability and greater volatility and the language establishing the cap creates ambiguity. Alternative investments involve inherently riskier strategies and permission for deposit institutions to engage in these investments keeps alive the notion that commercial banks are hybrid institutions – part deposit institution, part strategic investing or underwriting institution. In addition, the absence of precise definitions for the classes of capital that will be used to measure and limit banks’ alternative investments leaves these questions to regulators’ interpretations. Moreover, determining how banks measure capital and capital requirements is often debated, seldom universally agreed upon and subject to international application because of the integrated nature of international financial markets. As a result, we may have taken a much smaller step towards market reform than touted by the bill’s proponents.
Proposed language in the Volcker rule regarding banks’ proprietary trading activities also appears to be watered down and similarly ambiguous. Earlier versions of the bill would have altogether eliminated proprietary trading, or purchases and sales by banks of securities and other investment products for their own accounts. The language in the version of the bill adopted by the conference committee allows banks to engage in “market making activities,” or “trading that facilitates customer relationships.” Again, the regulators’ interpretation of the definition of “market making” will be the test of whether this provision has sufficient teeth to mitigate the concerns that motivated the inclusion of this provision. Distinguishing between market making and proprietary trading activities is not always easy. A bank may engage in a trade today on behalf of a customer looking to sell a security or an asset (market making activity) and that transaction is easily transformed into a proprietary trade tomorrow when the bank makes a strategic decision to hold or dispose of that same security or asset. Drafters will therefore need to spend some time improving the language to avoid the types of loopholes that would permit abuse of this exception.
Similar issues have arisen in connection with Senator Lincoln’s proposal to the limit federally insured banks from engaging in derivatives trading activities. Lincoln’s controversial amendment, which would have imposed a complete ban on such activities, has lost some of its sizzle. The version of the bill adopted by the conference committee would allow banks to trade currency, commodity, interest rate and certain credit derivative swaps. Why does the bill allow banks to continue to use of these types of derivative instruments? Without the ability to share the risks related to lending activities, banks argued that they would be less willing to lend and credit markets would contract. In contracted credit markets, banks explained, it would be harder for all parties that rely on credit to borrow, including businesses that borrow for payroll expenses, individuals borrowing to buy cars or automobile manufacturers borrowing to stay afloat. The most disconcerting aspect of the committee’s version of the bill lies in its thin definition of the parameters around banks’ use of these derivatives investments. In the version of the bill adopted by the conference committee, banks may only use these derivatives instruments to “hedge” or protect themselves from exposure to genuine risks of loss. Banks may not, according to the bill, use the derivatives instruments to engage in speculation. There is no attempt to sort out which activities constitute hedging or speculation in the legislation. This punt to regulators may prove especially challenging because they have struggled with distinguishing between activities that hedge against risks and mere bets.
By including these exceptions and failing to create more substantive definitions for some of the more critical terms, the drafters of the proposed financial reform bill may have created loopholes that are just big enough to lasso and diminish the effectiveness of each of the noted rules.