Notes from “Evaluating the Volcker Rule” conference in DC 11/9/11

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Americans for Financial Reform put on a conference on 11/9/11 in DC at the Hart Senate Building. You can find the event details here:

What follows are my notes from that meeting.


Anthony Dowd — chief of staff Paul Volcker

Nick Dunbar — author “Devil’s Derivs”

Gerald Epstein — prof econ UMass at Amherst

William Hambrecht — CEO W. R. Hambrecht & Co

Kimberly Krawiec — Duke Uni Law School (could not come)…. Malcolm Slater — harvard biz school

Matthew Richardson — NYU/Stern Prof applied economics


Sen Merkley:


I first became involved with this b/c Andy Green put before me a piece that Paul Volcker wrote that said we should not have this type of high-risk gambling inside these financial institutions. Were not optimistic about it passing, but said this is the time.


Andy put out an email to his compatriots around the hill and sen levin came up to me on the floor and said that he wanted to be involved, and wanted to focus on conflict of interest. Tony Dowd who was really a key facilitator with P Volcker and bringing his expertise to bear. A lot of folks then joined in that community to work on this issue. A large number of folks working on a very key problem, that we thought had very slim prospects.


It is a critical piece of the puzzle. Volcker takes deposit-taking loan-making businesses out of the hedge fund business. Now of course hedge funds have their place, buut that place is not for FDIC insurance and taking advantage of the Fed discount limit.


I think about it a little how I would have lived my life as a bachelor, playing roulette, w/o worrying about who it affects.


Now our goal is that the rule as implemented matches the rule as intended.


3 yrs ago we were all standing in the aftermath of the implosion of the worst financial crisis in …. years. This crisis had many causes, all man-made. We had a culture where regulators rolled back regulations. We had banks making teaser rate loans that then became exploding interest rates. We had credit ratings agencies that allowed Ibanks to package those loans and sell them off w /AAA ratings. And then we had an enormous industry selling CDSes. ANd we had major firms that we taking advantage of deregulation. Then in 2004 we had 5 banks given an exception to the leverage requirements. Some firms began to realize the risk and began to offload some of the risk to their customers. I thin it’s important … like the person you hire to wire your house, that person taking out multiple bets that your house will burn down. That’s a pretty deep conflict of interest. 2008 $200 BN in trading loses. $16 TR in loans that were extended by the Fed. The consequences were enormous. 1 in 4 american homes underwater. Families owing more than the value of the house. Now we have the crisis in europe, in many ways an aftershock of 08. Greenspan and others policy were a colossal failure.


We must deal with this problem. It’s a problem we should be recognizing going back to LTCM. Bringing Nobel prize winning experts to bear, and in the end a huge collapse with the NY FEd leading a bailout.


When Sen Levin and I started working on this, the sentiment was that this was unlikely to go forward. Most everyone thought that it would be impossible to take forward. It was a huge effort — given how hard it is to get an unanimous amendment.  You might recall that some of my colleagues acrorss the aisle said “that’s a terrible thing to do to compromise this amendment” everyone said they were happy to sever the issue. Even offered to a 60 vote rule w/ 2 senators who would have voted for it were not present. So I had … while it couldn’t get done on the floor of the senate, … outside groups made it possible to get it done in (?? a conference)


Now we are in another phase. Plenty of complexity to sink your teeth into. I’m sure there are plenty that will try and gut the regulation. They will complain how it will destroy Western Civilization. But it was deregulation which almost caused the end of Western Civ.


Hedge funds are meant to be risky. MF Global should remind us of that [editor: MF G not a hedge fund, but they did prop trade].


Need to distinguish between hedging and market making and true prop trading. I encourage you to get your friends and neighbors involved.


Out of the great depression came a foundation that served us for many decades. Our challenge is to do the same.


Sen Levin:


Great to be in this particular setting.


Media circus from Goldman hearing mostly centered around the four letter word used in their emails.


Bank in Wash called WaMu that engaged in a conflict of interest selling junk to customers. How those mortgages then became the collateral for securities. The regulator that was supposed to make sure that the bank’s mortgages were ok did not happen due to a conflict of interest in the office of thrift supervision. Their income was derived in part by the fees from the very banks that they were supposed to regulate. Dodd-Frank put the office of thrift supervision out of biz. Next is ratings agencies giving AAA ratings in order to please their clients. A credit rating agency email saying “if we don’t give AAA rating the other agency will and we’ll lose the biz.” Sen Franken had an amendment that would have done better but wasn’t [? accepted ?].


Some of the language that’s in Volcker Rule came out of a conference


The Hudson Mezzanine. This security was based on a bunch of bad mortgages in GS inventory that they wanted to get rid of. In the marketing materials they said that the interests of GS and the interests of the prospective purchaser were the same.


Language of Volcker not far enough w/r/t conflict of interest. I’d make any disclosure opportunity prominent. I would not just give the client an “opportunity” I’d require that the client “expressly accept” and that it would need to be written out. I’d make the client say “I acknowledge” and sign it.


They allow either “timely and effective disclosure” or you can put up “information barriers” so that the covered bank has physical separation to prevent the conflict of interest. These walls. Those walls are too easily breached, I never thought them particularly effective [ed: Chinese Wall].


It says “disclosure OR information barriers” and I would change the “or” to an “and”


We are going to have at least a 250 page comment. I’m going to see if I can stay awake reading it. That’s what my staff’s test is.


There’s a whole lot of power on the other side of this issue with thousands of lobbyists working 24/7.


The Volcker Rule comment deadline is Jan 13th. We desperately need voices speaking out in the public interest at the center of this public debate.



Put up FDR quote, “require two safegaurds vs. evils of old order… end of speculation w/ other people’s money.” We have to rediscover principles of the Volcker Rule every couple of generations.


Challenge to regulators is to manage connections betw MMing and hedging w/o loopholes. Structure of Volcker statue… statue starts out by imposing a sweeping ban on all prop trading in all trading accounts. Trading book was the vehicle of the worst excesses of the walls t banks.


certain activities are permitted but only on the condition that it does not present systemic risk.


powerful tool for regulators and a tool that demands a systemic perspective.


Two panels are going to address 2 goals of Volcker Rule


  1. changing institutional culture in big banks to address regulatory arbitrage, excessive risk taking


  1. limit systemic risks




Regulatory compliance starts at the top. REgulators are subject to political, biz pressure. If regulator is going to walk into a corner office of a CEO’s building nothing is better to stiffen his spine than a strong rule.


Jan 2010 when President announced Volcker rule which was a surprise to us + Volcker, we referring to it in a memo of a longer name.


Context … when volcker sat down to prepare plan to address “too big to fail” and moral hazard, looked at all bailed out entities, not just banks,and ask “who are we willing to protect?” His answer was that “we’re going to protect the banks.” Mr. Voclker has always felt that the banks were special. Chief provider of credit for indivs and small biz. All sophisticated companies protect their banks, long felt impossible to have a healthy banking systems to have a healthy growing company. Next question is “what is a bank” which is a very difficult question esp after Grahm-Leach-Bliley.


We used the activity restriction as the most politically feasible way of doing this. Easier than going back to glass-steagall. Instead of looking line-by-line at what banks SHOULD do, we decided to address what they should NOT do.


Volcker Rule is really about defining a bank for the purposes of “too big to fail”. Draw a bright line around the banking system.


Volcker testimony:

“we need to maintain a distinction betw banks and capital markets … discourage assumption that non-banks will be rescued”


One of the good things that came out of the MF Global was that it was allowed to failed and born on the shareholders and required no govt support.


W/O the Volcker rule, we feel that the lines of responsibility for the regulator would be blurred. You have a more defined license as to what the govt is going to protect. I think we all agree that if a hedge fund/private equity fund blows up that no one should be bailing them out. Thus It’s very hard to protect those same entities inside a bank. Two ways to build culture: on the way up (Startup), start at the top (old institutions)

Must hold boards of directors and sr mgmt responsible for compliance. Hope to see more customer focused culture develop which would lead to a greater stability of the financial system in the future.




I’ve been writing about finance since the late 90s. I first got into this b/c I had some friends at Harvard where I was a physics grad student. Friends went to wall st. I was becoming a journalist.


I was commissioned to write the devil’s derivs by harvard biz press. When I was pitching the book, people said “the banks got bailed out. No one will read this.” The book has a lot of detail in it, so it’s a resource you can use. I work for bloomberg now but don’t speak for them.


You have two worlds. Main st, where ppl are risk averse, and wall st. This comes from behavioral finance. There are risk takers like entrepreneurs, they drive economic progress, but they are rare and pay a price for their visions.


Wall St

Being hedged vs the downside changes the psychological perception of risk. Been writing about the development of these crucial aspects of financial technology. Black-Scholes where you can replicate any payoff with a dynamic hedge. Helped drive this change in risk perception. It was a “love to win” credo.


WALL ST firm used to do something for the economy, take risky assets, company that needs capital for example. wall st would package it, do some due diligence on it, and securitize it. that changed when you had this new technology. You had a trading desk, and then a special purpose vehicle


Correlation trading looks like market making.


credit spread arbitrage looks like private placement underwriting. ML and Barcap doing this in the early 90s.


Derivatives made underwriting and market-making interchangable


In 2007:

what starts out as a matched position becomes a prop trade.

Hedge Funds —> Trading Desk —> CDO investors


Prop Trade

Trading Desk —> CDO investors


Trade served as a macro hedge for warehoused subprime risk, accrod to DB and GS


Exemptions to be wary of:

  • Securities lending. AIG essentially did prop trading.
  • Repo
    • MF Global used repo-to-maturity to execute an arbitrage trade it couldn’t support, leading to bankruptcy.
  • Exchange Traded Funds liquidity positions
    • TRADING DESK THAT PROVIDES liquidity, etf investors and then cash commodities/FX. Half the ETFs in Europe are constructed using swaps




Annie Green

I have in a different life spent time as a consultant on wall st, commodities side of the house

My theme is Henry Kissinger. 52 years ago I took a course on European history 1848-1948. I don’t remember anything from that course, but I do remember my instructor repeating “In the world of diplomacy, execution dominates conception.”
One of most important policy goals is changing executive behavior and culture. I mean mean shared decision premises, and bureaucratic decisions. PLace to start is with compensation and incentives.


I’m going to ask you to think what outcomes you would predict for each of the following business practices:

what if I told you…

  • the bonuses of the deal structures of the traders are based on teh estimated present value of the profitability of the trade
  • commodity contracts are marked to some theoretical value rather than to market
  • performance pay for sr execs ignores comparative biz performance (everyone in industry made 20%)
  • stock options are not indexed
  • no look back, no claw back
  • 80% of executive pay was equity based
  • degree of bank directives wealth at risk is minuscule
  • private banking partnerships are responsible for the welfare for past and future partners no longer exist


I would predict inevitable breakdowns.


I have a preference for principles-based regulation vs rules-based.
Federalize executive compensation strikes me as problematic. I have some suggestions of indirect ways of getting here. I’d put the battlefield at NYSE and NASDAQ instead of here.


Principles that we ought to keep in mind going forward:


5(B)(C)(vi) executive compensation


Stock options not indexed to the moves of capital markets


Insiders are in conflict with ordinary shareholders



What a lot of these wall st firms will do is that they are always looking for shelters. They will have a boiler plat 10-q here they say that they will say things like “we have short term positions blah blah bla”


I think the trick is looking at the scale of it. A way of distinguishing between what they have to do. Facilitation (of client positions)

one angle about this … what if they just took that arbitrage, and say they need to do this or else mkt liquidity will disappear. Why don’t they then just sell that profit to investors… customers can then get access to this via a fund. Make sure that external investors can take that external risk. But yes, it does need to be checked in terms of how firms are doing that.


Q: Wally of Better Markets

Real key issue of dealing with volume vs liquidity. High freq trading

GS and MS became banks. Now they’re very likely to become unbanks. Isn’t it very likely that if things become rough again, they’ll become banks again. DOesn’t that defeat your purpose?
A: Volcker has said that he views the success of this rule as to whether or not Goldman gives up its banking […designation]


If FSOC is doing their job, Goldman shouldn’t be so entagled, again, with the world’s financial system that the entire system stands to fail.


One of the things about liquidity I never believed is a panacea. You hear these arguments that Volcker is going to reduce liquidity. Maybe this reduced liquidity will return them to more traditional things.


From Merley staff:

Volcker rule is drafted. Core positions cover non-bank financial companies as well. GS or MS would still be overseen by the federal reserve. Volcker would still regulate them through capital reserves etc.


Q: Suzie Kim reporter Washington Post

Reports that Volcker has soured on his own rule. Not happy how it exploded to hundreds of pages. He’d scrap the whole thing and start over with stronger regulators.


Mr. Volcker is frustrated by some of the exemptions worked in. If we could push a button and have the Merkley-Levin amendments [that did not make it in] we would. Rule itself is 35 pages with a 33 page appendix. 250 pages of questions. There are exemptions that can be gamed.


I think Volcker is hanging his hat on the strong wording of general .. of prop trading. We never really seriously considered returning to glass-steagall. I was in the private equity biz for a long time. Prohibition on prop investment activities had a more feasible chance of being passed.


Much of the complexity that people are complaining about were added as a result of lobbying.


Sen Levin staff: Hedging portfolio manager compensation risk was a little surprising.


Q: David A from public citizen. Wonder what you think about arguments that Volcker will hurt international competitiveness?


A (Dowd): That’s all you hear. This is one of my favorite questions. In biz, the quesiton is “what are we competing for, and who are we competing against.” Every st corner in NYC seems to have a branch. They compete for deposits. The thought that ppl would feel comfy putting their deposits in a thinly capitalized French bank vs a well-capitalized Volcker Bank. The ability to go after deposits is enchanced by the capital requirements.


Prime Broker, Market Making exempted from Volcker Rule anyway. Main example of competition is two prop traders competing against each other.


(Slater) First movers have the advantage.


(Dunbar) these remind me of the complaints against Basel II. That higher ROE is somehow safer for society [said with lots of sarcasm]


Q: What opportunity do we have through the NVR to … put conditions on usage of the exemption to actually get what we want. For ex, if there’s a market making expemtion that’s being relied upon, market making should not create a compensation incentive.


A: I have a litttle bit of a problem w/ federalizing compensation is problematic. THere is nothing that puts the heart of CEOs is having to attest


There are no blanket exemptions in the Volcker rule


Section 956 in Dodd-Frank

A blanket directive to regulators to ban all executive compensation that creates excessive risk-taking. Regulators have come out w/ a rule…





best thing is to put a surcharge on financial transactions.


second best solution is to put hard constraints on what financial institutions capital should be


Many things that banks do are systemically risky… loans, fee-related biz like asset mgmt . but many of these risky things are core to the banking system. Principal/Prop trading this is not true.


It’s non-core b/c these activities can be done outside the system. banks and large complex firms have access to the safety nets. If you look at their funding rates, it looks like there is an implicit “too big to fail”. That’s going to cause a much higher leverage rate than normal.


near fatal investments in asset-backed securities as a way to avoid capital requirements.


We should not ignore:

  • carry trades and exposure to tail [eg long tail] risk (rule is ambiguous)


fannie freddie and the banks had almost the same amount of risk

banks had $901 bn of agency RMBS and $483 of non-agency [ed: i.e. not their crap but other people’s crap]


hedging / mm-ing loopholes exist but are of 2nd-order importance. Main thing is tail risk.



to the ppl drawing the rule: it’s extraordinarily hard to define what is an agency trade and what is a prop trade.


the minute you act as principal it’s hard to define the motivation of the trader. I would say that any of the exemptions that are in there are going to be sorely tested by the traders who feel that their trade is an agency trade.


i think it’s very important that the volcker rule be extended to the non-bank companies.  broker-dealer capital adequacy rules are much looser than in a traditional bank. A lot of ppl point to a ruling in 2003 [ed: he means 2004] when SEC allowed siz banks [ed: he means five banks] … the interesting thing about it. The 12/13:1 was not a statutory requirement. The requirement was a capital adequacy rule that would sometimes allow them to go to 100. The SEC put in as a guideline. The B/Ds went to the SEC and pleaded it wouldn’t allow them to be competitive. Intra-day trading they’d sometimes exceed 100x leverage. Enormous risk created. To me, the problem that has to be addressed is leverage. How much leverage are they putting into the system. Under existing B/D rules, it will be jsut as easy to do it all again.


I remember ppl asking me why did he every go to MF Global at all? The answer was “that’s where he could get 34x leverage.” WEek they went under, they were operating at 34x leverage. This will attract anyone that does well as a trader. There are a lot of great traders out there, and this platform attracts them.


the justification that’s been used previously is that b/ds provide liquidty to the market. But as computes have taken over most of teh trading, the computer matching systems put a buyer/seller together … dont’ require an intermediary. Specialist funciton has dropped significantly. Justification that they need unlimited leverage is unwarranted now.


Free credit balances created by delivery of short positions. Prime broker can borrow the stock from its customer base. Deliver it to the buyer of the short sale. Get the proceeds and keeps it as collateral. He does not put it in the customer account.
The second loophole is repo. I still have no idea why repos are allowed. One of the first things I learned is the business is you don’t borrow overnight. The repo market were what the big B/Ds used to finance this mess.


Our suggestion is that the only way you’ll ever control leverage is the way the Fed has controlled it for 75 years. Through MARGIN REQUIREMENTS. You should be subject to margin requirements just like every other type of comapny. If you’re on margin and the stock declines, you must post more collateral.


Exchange-traded, and a realtime system that sells you out rather than waits for you to put up more money.


I would suggest that rather than worrying about what’s a prop trade vs an agency trade, I’d focus on making real margin requirements so the big banks must play by the same rules as every other market participant.



Many people still claim that prop trading did not play a key role in the crisis. and that is simply not true.


WHat is the function that liquidity is serving in the market. Keynes said that excess liquitity can be anti-social. Can contribute to a lack of commitment by investors to long-term investment.


What banks were really doing was warehousing risky trades. Banks borrow enormous amounts of funds through short-term repos, building enormous leverage on their balance sheets.


Under maket-making new products can be designed and then customers are sought out to buy them. This is not “MM” in the sense that there is a body of prior customers seeking a makret in particular products.


[ed: that would mean that no financial institution could ever create a new product, ever. how would this ever be admitted? ]

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