Column: Wasting the crisis

Written by K Vaidya Nathan | Updated: Dec 12 2013, 10:35am hrs
Craftsmen who want to strike irons into shapes that suit them know that the iron must be hot and their hammers must be ready. This is true for craftsmen of financial regulations as well. Five craftsmen of financial regulations in the USFederal Reserve, CFTC, FDIC, OCC and SECyesterday issued final rules to craft the Volcker rule, a regulation named after former Federal Reserve chairman Paul Volcker. The Volcker rule prohibits insured depository institutions and companies affiliated with insured depository institutions, i.e. banking entities, from engaging in short-term proprietary trading of certain securities, derivatives, futures and options on these instruments, for their own proprietary account. The Volcker rule also imposes limits on banking entities' investments in, and other relationships with, hedge funds or private equity funds.

Regulatory irons were heated in the aftermath of the sub-prime crisis when major investment banks were in trouble. Some regulators and academics blame the 2008 financial crisis on Glass-Steagalls repeal, at least in part. It was therefore an appropriate time for the regulatory craftsmen to reinstate the commercial bankinginvestment banking firewall by introducing the Volcker rule. The Volcker rule, in my view, is the regulators fremium version of the Glass-Steagall Actbanks now dont have to pay a regulatory cost for the basic banking services, but there are regulatory tabs attached for the more exotic financial services. Glass-Steagall prevented a certain type of institution, whereas the Volcker rule prevents a certain activity. For instance, a bank like JPMorgan Chase, which takes deposits and makes trades, would be prohibited under the Glass-Steagall Act, but under the Volcker rule, JPMorgan can still exist but it just wouldnt be able to make certain types of trades, especially the proprietary ones.

Just because the regulators have stuck when the iron is hot doesnt necessarily mean that they have stuck well. If the Volcker rule works the way it is intended, a banks profit in a few years would only be derived from the difference between interest earned on loans and interest paid on depositsthe way banking was done in the good old days. However, the transition seems unlikely to happen.

First of all, large banks do not want to return to plain vanilla banking as the profit margins are pretty thin in those traditional businesses. But even if they indeed had the willingness to do so, it would still be a difficult proposition as all the large investment banks have a pretty complicated balance sheet in this day and age. Their exposures are not only to equity, debt, currency and commodity markets, but also to the derivatives of all of those asset classes. For instance, if any of the above markets unexpectedly tank, a bank may lose money. To protect against that, banks hedge and that is allowed under the Volcker rule. Banks can continue to take opposite positions, so that if one part of their portfolio loses money, another will gain some of it back. Hedging is vital to these banks solvency, and so the Volcker rule allows this practice.

However, for a large investment bank like JPMorgan where I used to work, hedging is incredibly complex. Bankers draw up sophisticated pricing models and implement intricate algorithms to hedge the critical exposures in the complicated balance sheets. These models are vast and nuanced, and many a times do not work the way they are supposed, because at the end of the day, it is difficult to model a reality called global financial markets. More problematically, a bank can claim that virtually any trade is a hedge, since they deal in so many exposures that its impossible to clearly pair up each trade with its offset. And if every trade can be called a hedge, a ban on trading is no ban at all. In fact, I would think that banks can still trade proprietarily to their hearts content under the garb of hedging. More so, because large investment banks know that regulators would never be able to definitively separate speculation and hedging. Given that large investment banks have balance sheet size in excess of $100 billion that include everything from plain vanilla loans to a derivative-flavoured alphabet soup of financial products, no bank would have to look too far to find a trade that can be given the pseudonym of a hedge. Consider JPMorgans infamous London whale trade More demons from Dimon (FE, May 17, 2012, http://goo.gl/IpbMzn), in which JPMorgan lost more than $2 billion. The trade was supposedly meant to be a hedge. As JPMorgans CEO Jamie Dimon said on a conference call during the whale trade debacle that the synthetic credit exposure which was meant to be a hedge was badly executed. It is not difficult to imagine that if a CEO like Jamie Dimon had to hypothetically stand in future before a congressional committee and explain why a toxic trade complied with Volcker, he can do so with ease. Many bankers do not understand the complex calculations behind hedging, so its impossible to expect legislators to. The legislators and regulatory craftsmen seem to be wasting a crisis. A crisis is a hot iron which must be struck fast but more importantly struck well. But the five regulatory craftsmen seem to have missed the mark to adroitly mould financial regulation.

The author, formerly with JPMorgan Chases Global Capital Markets, trains finance professionals on derivatives and risk management