As the Industry Spread has documented, Texas Republican Congressman Hensarling has been on a financial jihad against the Volcker rule, arguing it creates illiquidity in the corporate bond market, but is this is an accurate analysis of the market?
What is the Volcker rule?
The Volcker rule “prohibits banks from proprietary trading and restricts investment in hedge funds and private equity by commercial banks and their affiliates. Further, the Act directed the Federal Reserve to impose enhanced prudential requirements on systemically identified non-bank institutions engaged in such activities, “according to a paper by the Securities Industry Financial Markets Association, an industry trade group.
In layman’s terms, banks could no longer trade in their own accounts.
The Volcker rule is named after a legend in the world of high finance, Paul Volcker. Volcker took over the Federal Reserve when Reagan took over the US Presidency; at the time, Reagan faced stagnation, meaning high unemployment and high inflation, and Volcker raised rates further deepening the recession but fixing inflation before Reagan’s tax cuts created high growth to go along with Volcker’s low inflation rate.
Though it’s named after him, the roots of his rule start in an event which occurred two years and forty-nine days after he was born on September 5, 1927: The Stock Market Crash on October 29, 1929.
Before the crash, banks could “trade in their own account” and a bunch of other high-risk things, doing much of it recklessly.
William Donaldson, a former Securities and Exchange Commission (SCE) Chairman from February 2003 to June 2005, once said in an interview about that period: “If they were underwriting a stock offering and had trouble getting rid of the stuff, they would buy it with people’s deposits.”
As a result, Congress passed and President Roosevelt signed the Glass Steagall Act in 1933, named after Senator Carter Glass, a Democrat from Virginia, and Representative Henry B. Steagall, a democrat from Alabama- which separated investment banks from commercial banks.
That’s how things stayed until 1999 when the Gramm–Leach–Bliley Act (GLBA) repealed Glass-Steagall.
The effect was that when the real estate boom hit, starting at about 2003, banks could participate in all ends of home mortgages: from giving real estate loan to selling that loan to a mortgage securitizer, to being the securitizer, to buying the end bonds, to buying and creating credit default swaps (CDS) and collateralized debt obligations (CDO) banks did all parts, including things they knew little about.
When the sub-prime crisis hit in 2007, banks were especially exposed, and this was the catalyst for the 2008 financial crisis.
The role the repeal of Glass-Steagall remains a matter of debate but there’s no doubt it had some effect.
The Volcker rule was initially proposed as a sort of “Glass Steagall in spirit,” according to the site, Economic Mix, after the crisis.
For proponents of the rule, the best argument, especially if it’s ceded that the repeal of Glass-Steagall at least contributed to the financial crisis, is that to not do it would be the definition of insanity, “doing the same thing over and over and expecting different results.”
If it not being in place helped set off the 1929 stock market crash and the 2008 financial crisis why would there be a different result in the future.
Volcker Rule and Dodd/Frank
Paul Volcker first proposed the Volcker rule when he was appointed by President Obama to chair the President’s Economic Recovery Advisory Board (PERAB), a board President Obama put together to advise on ways to improve the economy.
In 2010, it became known as Section 619 of the act.
But implementation was delayed numerous times until on July 21, 2015, the Volcker rule finally went into effect.
Its Effect on Corporate Bonds:
Even before the rule went into effect, there were those who raised the same alarm that Congressman Hensarling is raising now.
“In particular, some believe that the Volcker Rule could affect the market for corporate bonds — securities that are often used to positively affect yields in fixed income portfolios — by decreasing liquidity and increasing trading costs,” according to a 2014 analysis by Chandler Bond Market Review, that analysis was done before the rule had even been implemented.
That doesn’t mean that Hensarling- who chairs the House Financial Services Committee which is the most powerful committee on trading issues- and his ideological cohorts are right. Little is settled on this issue and there are studies and statistics which will back-up both cases.
The Hensarling View:
For folks like Hensarling, a Marketwatch analysis summed up their position: “The Volcker rule is intended to limit banks to meeting customer demand. As a result, banks no longer maintain large inventories of bonds on their books for significant periods. Instead, they serve as so-called market makers to clients: buying from one client and selling to another at a higher price, thus making a market.
“Since these dealers, as the large banks are sometimes referred to, have shrunk their inventories, the size of the market they make also has diminished, many have argued.”
Opponents argue that rather than causing a lack of liquidity it merely moved that function to other parts of the market.
“Others argue that shrinking dealer inventories don’t necessarily mean liquidity is declining.” The same Market Watch analysis found. “Instead, it merely means ‘the role of dealers in the secondary bond market is threatened,’John Parsons, a financial economist and professor at MIT Sloan School of Management, said during a panel discussion on bond-market liquidity on Aug. 3.
“’Traders are no longer the main channel through which investors buy and sell bonds,’ Parsons said.
“’Electronic trading is how most people see the change,’ Parsons said, which gives investors tools ‘to meet up via a number of new channels, leaving the old dealer model as an anachronism.’”
The Volcker Rule and the Potential Dodd/Frank repeal
First, there’s an important dynamic to note. What is important to the trading community is not that important to the rest of the world regarding Dodd/Frank, and what the rest of the world is currently debating regarding Dodd/Frank is only indirectly relevant to the trading world.
While traders are interested in things like new margin and hedging requirements, the Dodd/Frank debate centers on things like whether the act has strangled community banks with regulations putting them out of business while making mega banks like JP Morgan Chase “too big to fail”.
What this means is that as part of any compromise, short of full repeal, regulations directly related to traders are likely to be political pawns, up for grabs as part of the standard horse trading which happens in back rooms when the details of bills are debated.
But that is not the case with the Volcker rule.
This rule is well-known and controversial.
The argument has largely turned ideological with Republicans mostly against the rule and Democrats largely in favor with the unpredictable Trump siding this time with the Democrats.
As with most things Trump, his presence has added an unknown quantity to the dynamic making predicting the future of the Volcker rule impossible.