Volcker Rules, OK for Bank Bondholders?

Guest contributor – Jeff Spencer (Financial Institutions Credit Analyst, M&G Credit Analysis team)

In an attempt to reduce risk-taking at financial institutions, yesterday President Obama announced a proposal to bar banks from engaging in proprietary trading activity that was unrelated to customer business. He also advocated that banks be stopped from owning or investing in hedge funds or private equity funds. This address was met with concern from investors, with highly-rated government bonds benefiting from their safe haven status and global equities and commodities falling over the course of the trading day. Investors are wary about the potential implementation and impacts on the banks profitability of the so-called “Volcker Rule” – named after the former Federal Reserve chairman who has advocated the move for months.

For me, it is important to delve deeper into President Obama’s announcement. In the accompanying White House fact sheet, President Obama, echoing a small portion of the Group of Thirty document released on January 15, referred to “hedge funds, private equity funds and proprietary trading operations for [banks’] own profit”, not “investment banks” or “investment banking” – an important distinction to bear in mind.

The equity market’s panic reaction to the speech indicates that financial institution shareholders understand that trading activity has at least partially underwritten huge losses in consumer loan books in 2009, and may ultimately be more indicative of a fear that the days of banks’ trading on the back of easy Fed money are numbered (shares of banks without sizeable trading operations were generally flat or up).  Fed rules already prevent depository institutions from providing liquidity to non-bank entities within a group, but on September 23, 2008, the Fed allowed exemptions for banks to fund activities that are typically funded in the repo market. This exemption was extended on January 30, 2009 but expired on October 30, 2009. New limitations on the scope of trading by regulated banks appear intended to complement these regulations.

Credit investors may or may not have new worries as a result of whatever new rules ultimately come out of Congress, but it is fairly clear that there will be some confluence of 1) higher capital charges for trading/markets activities (neutral to positive for bank unsecured bondholders) and 2) more emphasis, for regulated entities, on lower-margin trading activities, as banks appear likely to be forced to demonstrate to regulators that any trading they are doing supports customers and is not “proprietary”.  We do not think at this point that this means that investment banking divisions of large US banks (or, for that matter, non-US banks that own significant US broker-dealers) will be forced to be spun off. It could, on the other hand, mean that non-bank financial institutions may have to close or sell their insured depository institutions. Whatever emerges in the financial sector reform legislation, it may not be the blunt instrument that the market evidently fears.

The limit on bank size is potentially the more problematic new rule to enforce, but only because it is so unclear how it will be determined that a bank is too big to fail, and what the consequences of this will be once it has been made. Again, the President’s remarks need to be understood correctly: he said that he wanted to “prevent the further consolidation of our financial system”, not that he wanted to break up existing banks. As with trading activities, existing rules already address this topic with a ceiling on nationwide deposits at one institution; the question is what additional measures any new limit will actually target.

These two prospective additions to the House bill (HR 4173, which has passed) and to whatever Senate bill emerges from the Banking Committee have not yet been outlined in anything like detail, so anyone who claims to know what their precise implications will be, probably doesn’t.