PillartoPost.org / This is a long and complex blog from a progressive think tank regarding the proposed changes to current banking regulations. The same regulations that pulled the world out of the 2008 financial calamity. Whether you agree or not with this report—read it to be aware that the White House is playing around with your money.
Trump administration takes aim at Volcker Rule, future financial crises be damned.
The move to defang the Volcker Rule will leave ordinary Americans vulnerable to future shocks in the banking sector.
GUEST BLOG / By Jason Linkins, a senior editor at ThinkProgress, a news site with Center for American Progress Action Fund--A decade since the 2008 financial crisis upended the lives of hundreds of thousands of ordinary Americans, the Trump administration has largely performed precisely as you would expect a White House full of financial sector cronies to behave — gutting financial reforms such as the fiduciary rule and consumer-friendly retirement plans, which offered stiff competition to Wall Street products. But the most significant impact that the Trump administration has had on our financial future is its steady dismantling of the Dodd-Frank bill, which provided what thin protection we had against a future financial crisis of the same ilk that plunged America into the Great Recession.
ThinkProgress link click here.
Having already undermined Dodd-Frank’s effectiveness in May through the passage of the Economic Growth, Regulatory Relief and Consumer Protection Act, Trump administration regulators have lately turned their attention to the Volcker Rule — the Dodd-Frank bill’s regulation that created a separation in normal consumer banking activity from the sort of speculative trades that turbo-charged the financial sector’s volatility ahead of the 2008 crisis.
The dark warnings of what could happen as a result of undermining the Volcker Rule are already flying. Americans for Financial Reform note that while a “combination of industry lobbying and the desire of some regulators…has already led to a weaker Volcker Rule than the drafters of the statute intended…the Trump Administration is now proposing to weaken the Rule still further.” Securities and Exchange Commission (SEC) Commissioner Kara Stein is even more blunt: “[T]his proposal cleverly and carefully euthanizes the Volcker Rule.”
The Center for American Progress’ own recent report on the pending changes to the Volcker Rule, written by Gregg Gelzinis, offers this warning:
The changes are not tweaks. Under the guise of streamlining the Rule, the rewrite drives large and irreparable holes in the limits established by statute. By expanding exemptions, watering down definitions, eliminating certain compliance requirements, and transferring some oversight to the banks themselves, regulators are inviting more risk into the banking system.
“The overwhelming thrust of these changes would be a mistake,” writes Gilzinis, “but they are particularly dangerous when considered in conjunction with other actions taken by Trump-appointed regulators and his allies in Congress.”
In an interview with ThinkProgress, Gilzinis went into greater detail about what’s at stake for ordinary Americans, and how close we are to another financial meltdown. (Disclosure: ThinkProgress is an editorially independent news site housed at the Center for American Progress.)
The original intention of the Volcker Rule was simply to prohibit banks that were deemed to be “economically essential” from making these large speculative gambles known as proprietary trades. It’s been a decade since everything went kablooey in the financial system, so I was wondering if you could take us back to the ancien regime and explain how these practices wrecked the economy.
So, this was certainly one element of several things, unfortunately, that kind of came together in a perfect storm for the 2008 financial crisis. Banks with access to government support, whether that’s through federally insured deposits or the Federal Reserve’s discount window, are part of this safety net that we as a society have said, “It’s important to keep this really important economic sector stable.” Throughout history, without government support, the financial system was highly volatile. We had a lot of crises and it really impacted economic growth and the well-being of families across the country. So we put this safety net in place for banks with the idea that if I bring my hard-earned cash to the bank, put it in as a deposit, they’re going to loan it out. In the traditional business of banking, it’s going to help the economy that way.
But several policy decisions kind of eroded that principle, first among them the erosion of the Glass-Steagall Act which was enacted after the Great Depression to draw a line between speculative Wall Street trading and this kind of plain boring vanilla banking that I just described — where a bank makes home loans and consumer loans and corporate loans. Over time this line was eroded by regulators’ decisions, and then, ultimately, by repealing those sections of Glass-Steagall in the late 1990s. Then in the 2000s, we saw the emergence of these massive universal banks, where part of the bank would be this traditional commercial bank, but another part of the bank would be this Wall Street trading operation.
Citibank is a good example.
Citibank is a perfect example. So, these banks would engage in what we call proprietary trading. What does that actually mean? It means I’m trading financial instruments for the bank’s own profit, as opposed to making trades in service to clients — which are trading activities that we can debate whether they should be in the bank or not, but we at least see the economic value for these banks which, again, have access to these taxpayer safeguards. So they should be doing things that are oriented towards clients and towards the real economy. Whereas acting like a hedge fund and trading financial assets — stocks, bonds, derivatives — for your own profit, that’s pure speculation. That’s gambling, using the taxpayer safeguard to help you do that at a lower cost.
And those famous swaps from say, The Big Short, where people were making bets and hedges about how mortgages were insured, are a good example of this kind of trading.
Yeah, absolutely. A lot of the trading in mortgage backed securities, CDOs…banks were certainly doing that for their own profit. Even though they might say that they were doing it for clients, it was more the other way around where they’d create these instruments and then go market them.
“They were gambling using taxpayer deposits. And when those bets went south…that simply exacerbated the crisis and lead to even further losses.”
So anyway, the Volcker Rule banned proprietary trading at banks with access to the federal safety net, but it also heavily restricted the activities that banks could engage in with hedge funds. Because if you think about it, if banks were not allowed to engage in proprietary trading, but were allowed to own or invest in hedge funds, then that’s just a way to circumvent the ban on proprietary trading. Because if I’m a bank and I put my money in a hedge fund, the hedge fund proprietary trades — and then if they lose money, I lose money. If they make money, I make money. That’s just a second order way to gain access to proprietary trading.
And if they do lose these big bets in this arrangement, of course, ordinary bank customers, taxpayers lose along with them.
Exactly. Exactly. And getting back to your question on the crisis, these banks lost hundreds of billions of dollars. Some of those losses were due to activities that we would consider above board. But a lot of those losses were incurred on speculative, proprietary trading. They were gambling using taxpayer deposits. And when those bets went south, when the rest of the system was under stress due to the collapse of the mortgage market, due to lax regulations on other parts of the financial system — including derivatives — that simply exacerbated the crisis and lead to even further losses, which in turn led to big bank bailouts. It was just a disastrous result for families across the country.
So post disaster, the Obama administration and Congress are working on the Dodd-Frank bill to prevent these kinds of things from happening again. And one of the features of that bill was the Volcker Rule, which I suppose we could say is Dodd-Frank’s analogue to Glass-Steagall. It was Glass-Steagall-ish. I know it has its critics among the bank reform set, who have fretted about whether it was going to be truly be a super effective firewall between these two types of banking activity. How would you rate its effectiveness?
So in terms of the statute itself, in 2010, I think it was written in a very strong way. It really did give regulators the authority to implement a 21st century Glass-Steagall to separate some of these dangerous high-risk trading activities from the trading activities that fall in line, thematically at least, with traditional banking and traditional lending.
In terms of how the regulation, which was finalized in 2013, how that’s worked, it’s a little bit more unclear. Part of the reason is that regulators have not provided us transparency on the metrics that the Volcker Rule require them to collect from banks on their risk-taking, their trading inventories, and how they’re making profits. All these things that would really give us a good insight on how the rule is working are things that the public hasn’t been able to see. So it’s tough for me to sit here and say that the rule is working or isn’t working. The fact that banks are lobbying furiously to roll it back leads me to believe it’s had some impact.
But what Trump-appointed regulators are proposing would seriously gut the rule. And I’d be very confident to say that the rule would not work if those changes were made.
One of the things that’s always struck me as odd is that everyone who engaged in these risky activities knows full well that it was the lack of guardrails that did them in. Their own livelihoods, their own businesses were damaged, nearly destroyed. So why is there such resistance to a rule that would simply demarcate where and with whose money these bets get staked?
Yeah. So I’d say two things. One, these activities were highly profitable.
I suppose so! (Laughter)
Banks, because they’re a node in the financial system, have access to a lot of data and a lot of information which can be very useful if you’re trying to speculate on the direction of certain assets. That’s an extremely profitable business line and so that’s one reason why they really pushed back against the Volcker Rule.
“The fact that banks are lobbying furiously to roll it back leads me to believe it’s had some impact.”
But then — to the point on the financial crises — banks don’t pay the cost of financial crises, banking executives don’t pay the cost of financial crises. It really is the broader economy. It’s working families that do. If you look up the net worth of the various bank CEOs that brought the economy to the brink of collapse, many of them are wealthier today than they were in 2008. You can’t say that about most middle and lower class families in this country. So it’s a “Tails I win, heads you lose” situation.
Logically you’d think they’d want to have the appropriate guardrails in place because then we won’t have a crisis, and their business model might be able to stay in line, and populist pressure won’t rise up to try to take them down, but they’re not thinking that way.
Well, let’s get to the brass tacks. What are the Trump regulators proposing that we actually do to the Volcker Rule?
The one overarching theme is that they’re handling a lot of the power back to the banks themselves in terms of regulating themselves.
They’re guarding their own henhouse.
Exactly. Self-regulation, trusting the banks to abide by certain restrictions without having the tools necessary to ensure that they are.
So I’ll give you one example. One of the permitted activities under the Volcker Rule is market making. The Volcker Rule says that you can only buy and sell financial instruments and keep them on your balance sheet to the extent that they serve the reasonably expected near-term demand of clients. This essentially says that if I know, based on historical data — and regulators require these specific analyses to determine what client demand was — so if I know based on historical data, based on current market conditions that clients may want, say, 10,000 shares of Apple in the next week, then because I’ve shown regulators that this is what I think the client demand is, based on all these variables I was required to consider, then I can go out and buy the 10,000 shares of Apple. That’s fine, because I’m only trading to meet my expected client demand.
What they’re doing now is they’re saying, “Well, regulators are no longer going to require us to provide specific analyses. We’re no longer going to tell you that you have to take X, Y, and Z variables and produce a number for us.” They’re saying that banks get to set their own internal risk limit, using whatever variables they think are appropriate, using whatever models and formulas they think are appropriate, and as long as they do that, then they’re in compliance for the reasonable expected near-term demand.
“That’s one of the things that I looked for carefully: Where is the evidence that we need these changes? And they didn’t offer any.”
So you know what’s going to happen is these banks are going to spit out numbers for their expected demand that are much higher than they used to. Is that because their customer demand has actually grown? No, it’s because they’re creating space to make a proprietary trade. For example, if under the 2013 final rule, when they had to perform these specific analyses, it said that clients are gonna want $3,000,000 of a certain type of corporate bond, under the new risk limits that they can create for themselves based on their own self selected variables, it may be that banks determine that it’s $10 million of corporate bonds, whereas the client demand is actually still $3 million. They could be making a $7,000,000 proprietary bet that that bond is going to increase in price.
So that completely hands over the power over this important restriction to banks and the worry is that they’re going to be engaging in this proprietary trading activity under the guise of market making.
Hedging is another example that fits this theme of handing over a regulation to the banks themselves. Banks used to have to perform what are called “correlation analyses” If they classified a certain trade as a hedge to reduce risks on their balance sheet. Which, again, is an activity that we think is okay because as long as you actually are hedging, then you are reducing risk to your balance sheet. The problem is when you’re not actually hedging.
So the correlation analysis says, if “Instrument A” is hedging “Instrument B,” then in theory, the two should move in opposite directions, right? If “Instrument B” goes up, then “Instrument A” — the hedge — is supposed to go down and vice-versa because you’re trying to reduce risk. But if it’s the case that they’re moving in the same direction, then clearly it’s not reducing risk over time. So these correlation analyses, banks had to show their work to regulators, to say, “Hey, these hedges that we’re putting in place under to claim this permitted activity — we’re not engaging in proprietary trading — are actually reducing risk over time.”
Under the proposed changes to the rule, they won’t have to do that anymore. They don’t have to perform these ongoing correlation analyses. Under the Volcker Rule, if they were going in the same direction they’d probably have to adjust it because the hedge would lose its risk-mitigating status — it’s clearly not actually a hedge anymore. But under the proposed changes, the profit motive may cause them to not adjust it, because it’s actually making money, right? It’s a profit center. So again, you can see thematically how when you remove these compliance requirements that force banks to show their work and justify that they are actually trading under a permitted activity and not engaging in proprietary trading, it creates a lot of leeway for banks to engage in this activity.
We’re very much back to: “Guardrails are nice…But, profits!”
Of course, the argument that’s being put forward by the people who want to make these changes to the Volcker Rule is that they’re just streamlining it, they’re just simplifying it, making it easier for banks to do their business and making it less complicated. But as Americans for Financial Reform pointed out in their recent brief, which very much concurs with yours, things seem streamlined and simple already: Lots of prop traders have exited banks for hedge funds, the landscape is still thought of as “a generous scope for trading,” and whatever fears critics had that the Rule would adversely impact market liquidity — that hasn’t been borne out by the evidence.
So what’s the basis for the decision to start pulling out the wires of the Volcker Rule, right now?
Okay. Yeah. So, there is none. And that’s one of the things that I looked for carefully: Where is the evidence that we need these changes? And they didn’t offer any.
Regulators site their own experience implementing the Rule as justification for the change — not data, not even, just an ad hoc story, an anecdote to describe, “Oh well, two years ago Bank B wanted to do this, and the Volcker Rule, the way the regulation was written, prevented him from doing that. And so now we want to make this shift.” None of that, none of that was there.
“Look, the Trump-appointed regulators are not exactly heroes of financial reform and many of them have histories in the banking sector, so these aren’t stalwarts of strong safeguards here.”
So that was very disappointing because if you look bank profits, the FDIC reported last quarter, that bank profits hit an all time high and it’s interesting because the previous all time high was the quarter before. So bank profits are extremely healthy. Lending has been growing at a faster annualized rate than GDP.
So with healthy profit at all time highs, market liquidity better than historical norms, why are we doing anything? And if we do something, why are regulators not providing us with the data that justifies that what they’re doing. There really isn’t a good or rational basis for their changes.
Most of this just sounds to me like the natural consequences of having Steve Mnuchin as Treasury Secretary.
Yeah. Look, the Trump-appointed regulators are not exactly heroes of financial reform and many of them have histories in the banking sector, so these aren’t stalwart proponents of strong safeguards here.
One of the things you talked about in your brief is that these changes the Volcker Rule is coming alongside a lot of other changes that might make banks less resilient. What are those things that are coming down the pike?
Earlier this year, there was a big Dodd-Frank rollback bill that was signed by President Trump. This would roll back some of Dodd-Frank’s enhanced stability measures, enhanced financial safeguards, for 25 of the largest 30 banks in the United States. What are these enhanced safeguards? Things like stronger capital and liquidity requirements, living wills, enhanced risk management, standard stress testing. So all of those things are going to be applied in a reduced form, to banks that make up about 16 percent of the entire banking sector.
Those are basically the top four “What does Dodd-Frank do?” bullet points right there.
Absolutely. And these banks are, frankly, household names. These are banks like Ally Financial, BB&T, SunTrust… these are not your local community bank, these are banks with between $50 and $250 billion dollars in assets. There are people who argue that these banks aren’t systemically important. Yes, they’re not as systemically important as your JPMorgans. That’s a $2.5 trillion bank. But this class of banks received about $47 billion dollars in TARP bailout funds during the financial crisis.
“Financial crises are absolutely devastating to the broader economy, and rolling back the Volcker Rule only increases the likelihood of that future devastation.”
Regulators also proposed reducing the leverage capital requirements at the eight most systemically important banks in the United States. These banks include the likes of Goldman Sachs, JP Morgan, Citigroup, Wells Fargo, Morgan Stanley. So those banks would see their capital reduced by at the bank level — I don’t want to get too technical — but by about 20 percent each. And so that’s less loss-absorbing capital standing between bank losses and failures. So, to reduce the resiliency of our largest financial institutions at a time that we’re chipping away at the safeguards for institutions that are smaller, and we’re also rolling back the Volcker Rule — we’re inviting more risk into the system at a time when we’re rolling back the structural safeguards. It’s just a dangerous combination of deregulation.
When we talk about being protected by the Volcker Rule, what does that actually mean for average, ordinary Americans? How can the average American be harmed by the Volcker Rule being pared back?
The Volcker Rule, in my opinion, reduces the likelihood of a financial crisis. Plain and simple. The activities we’re talking about removing from the core banking system, the core traditional banking system are highly risky trading activities. So if we remove those from kind of the core traditional banking system, it reduces the likelihood that these activities will cause losses at banks which could threaten the stability of those banks and the stability of the financial system and perhaps even precipitate or exacerbate a financial crisis. If we invite more risk into the system by allowing these highly risky activities or giving banks more leeway to engage in these highly risky activities, then we increase the likelihood of another financial crisis. And we saw how that played out in 2008: 10 million homes lost to foreclosure. Millions of of workers out on the street. $20 trillion in household wealth evaporated. One of the regional Fed banks just came out with a report that said that the total losses in the crisis would be the present-day equivalent of about $70,000 in lifetime income for each American. Financial crises are absolutely devastating to the broader economy, and rolling back the Volcker Rule only increases the likelihood of that future devastation.
The Bulletin of the Atomic Scientists’ Science and Security Board maintains this metaphoric “doomsday clock” that’s intended to assess how likely it is that we are going to unleash a man-made global catastrophe. I’m not aware if there’s economic equivalent, but how close are we, right now, to a repeat of a crisis like the one in 2008?
It’s an interesting question. When I think about that question, when I think about the next crisis, I break it up into two buckets. One bucket is: “What will the shock be, what will the trigger be?” In the last crisis, one of the shocks — one of the main triggers, obviously — was the collapse of the subprime housing market. Then the second bucket is: “What does the structural safety of the system look like?” So, you can imagine a world where the subprime housing market collapsed, but the banking system, the financial system as a whole, had really strong safeguards in place. There would be a little bit of stress, but it wouldn’t collapse and we wouldn’t go into the Great Recession. It would be a problem, but it wouldn’t have caused stress in the entire mortgage market, or collapsed the entire financial system.
So there are two bucket, the shock and the structure. I don’t know where we are in terms of the shock. You never know. I don’t think anyone’s ever going to predict with any sort of certainty when or what that shock will be. But when we do things like roll back capital requirements at the largest banks, roll back these enhanced safeguards that were put in place by Dodd-Frank, when we roll back the Volcker Rule, we’re really impacting that structure side. We’re making the system less resilient to shocks, less resilient to stress so that when this does come — whether it’s in two years, five years, or 15 years — that shock that we’re not going to be ready for, is going to cause the system to collapse because we don’t have the appropriate safeguards in place.
These are meaningful changes. This is by no means a minor tweak to the Volcker Rule — these are significant impairments of the post-crisis regime. We should be having the conversation about strengthening the Volcker Rule. We should be talking about ways to build on the progress of financial reform. It’s kind of inexplicable, that right now, we’re having a conversation about how far we’re going back.