Some participants at Sifma’s Annual Meeting last month were telling me that the Volcker Rule would never see the light of day. They were confident that the proposed changes made over the past two years had made the pending Dodd-Frank reform unrecognizable, even harmful to financial services firms. Surely, the regulators would drop it — until they didn’t.
It’s true that there may be legal action by some titans in the industry to take on the official blessing this week of the Volcker Rule by the SEC, CFTC, FDIC, the Federal Reserve and the Office of the Comptroller. But even titans cannot definitively dismiss the distinct reality of the Dodd-Frank reforms and now the Volcker Rule.
“There’s a level of regulatory denial that exists at some firms,” says Sean Owens, director, fixed income research, for consultancy Woodbine Associates. “But a lot of others have seen the writing on the wall.”
The writing got clearer after the $6.2 billion “London Whale” derivatives debacle via JPMorganChase alerted industry participants and regulators to a loophole or two that must have scared them into action. Not only did JPMorgan get hit with a huge $920 million fine but the industry got slammed with a tougher version of the Volcker Rule. So much for the many prognosticators that said the incident would have no impact upon the industry. I guess there was quite a tempest in Jamie Dimon’s teapot.
One of the silver linings from the Volcker Tempest is that that hedging strategies for all firms may become more “deliberate, specific and effective,” says Owens. “[Hedging] can’t flip flop. It can’t change. The strategy can’t morph and evolve over time. That is what the regulators are trying to get at with Volcker.” The ever-changing Whale hedge took on a life of its own “outside of the normal capital markets trading books,” he adds.
There may be other big changes to come and depending upon one’s point of view they may or not be silver linings.
Owens notes that if firms have not already exited proprietary trading, they may start pulling back from it and other capital-intensive yet risky businesses. Major firms began a retreat from proprietary trading a while back to steadily unwind their positions.
“That doesn’t mean that they have curtailed proprietary risk-taking,” Owens says. “[But] there’s less juice in a lot of the capital markets activities and higher costs. Near term, you will see companies maintain their capital markets businesses. But I think a lot of firms see the writing on the wall.
“Eventually, it won’t be profitable to run these businesses the way they have been run,” Owens says. “Down the road, barring some unforeseen change, the future is not all that bright. Firms are going to have to reengineer their approach to the capital markets to remain profitable. Before, a lot of that was masked.”
The masking came as the pre-Great Recession markets were “a rising tide environment—a lot of profits, and firms didn’t have to be as efficient and there wasn’t much transparency,” Owens says. The markets now will be highly scrutinized as capital becomes scarce.
Overall, the impacts of the Volcker Rule will be evolutionary and firms will pare back on less profitable areas. “Some will go after massive amounts of customer flow and try to make up for the low volume on margins or they will exit the business entirely,” Owens says.
But as firms dive into the Volcker package, they will need exceptional employees with a wide array of skills, particularly a deep knowledge of the vagaries of compliance and the financial products that are profoundly affected by the new rule, Owens says.
Surprisingly, Owens foresees new financial instruments amid the Age of Volcker.
“Wall Street is the most efficient profit machine known to mankind,” Owens says. “The regulation is going to challenge the smart guys to come up with innovative financial products that are allowed under the new regulations and that transfer risk more efficiently.”
The biggest surprise may be the new role for banks where they are intermediating and transferring risk more directly as a result of the far-reaching Volcker Rule. “I think you’ll see banks in more of an agency role rather than a principal role,” Owens says.
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