Late last night, a revised version of the Volcker rule was passed by Congress' conference committee. It was watered down significantly from its original conception, championed by former Federal Reserve Chairman Paul Volcker. It allows banks to invest up to 3% of their tier 1 capital in private equity and hedge funds, but they cannot own more than a 3% ownership stake in any private equity group or hedge fund. The 3% capital threshold is a big enough loophole that most big banks won't have to curb their proprietary trading much, if at all. Moreover, the 3% ownership limit might even make banks riskier.
3% of Tier 1 Capital
How much is 3% of tier 1 capital? Here's a chart showing Tier 1 and 3% of that for five major banks:
As you can see, the big banks can still do an awful lot of proprietary trading. According to a report from CNBC earlier this week, the 3% limit will likely only significantly affect Goldman Sachs, which generates around 10% of its revenue from proprietary trading. The other banks' magnitude of proprietary trading will be largely unaffected. This could result in Goldman shedding its bank holding company charter, so to avoid the Volcker rule altogether.
The initial version of this draft would have used tangible common equity (TCE), instead of tier 1 capital. Rep. Kanjorski (D-PA) objected to the change, noting that banks have a great deal more tier 1 capital than TCE, so this revision allows a lot more prop trading. His amendment to revert back the language accordingly was rejected, however.
3% Investment Share Limit
The other aspect of the rule would forbid banks from investing more than 3% in any private equity investment or hedge fund. This will likely cause banks to have to reduce their interests in some of their holdings, but ultimately it may work to their advantage. John Carney of CNBC explains why:
The new limit will now give the banks an excuse to reduce the amount of capital they commit to a hedge fund, which was mostly done to convince clients that the banks had "skin in the game." In fact, banks were being forced to commit more and more money to the funds to compete against other funds.
By creating a ceiling of 3% in any single fund, the Volcker rule will now allow banks to say they have fully committed the legal maximum amount of capital to the fund. Customers will not be able to demand a larger commitment. The arms race stops at a stake of just 3%.
Another source in the industry I spoke with noted another reason why the 3% requirement could make bank balance sheets even riskier for a different reason. Now banks will do more trading in-house, instead of bothering to establish private equity groups or hedge funds that would be open to outside investors. Their risk could be less diversified and more concentrated.
In response to the Goldman-SEC case, this provision also included a section that would forbid banks originating asset-backed securities from participating in a transaction that could be a conflict-of-interest in regard to any such bond it issues for one year. For example, it can't sell an investor a MBS and then short it. While this might sound fine to anyone outside of Wall Street, the basic concept is somewhat incomprehensible.
If a bank owns a pool of assets, say mortgages, the MBS it creates would essentially amount to selling those mortgages to investors. In other words, the bank implicitly takes a short position by selling its mortgages, while the investor takes a long position by purchasing them.
In a less basic case, if a bank's preparing a synthetic collateralized debt obligation, then it must find two parties, one to take the long side, and another to take the short one. Now it can't participate in both sides of the transaction, however, since one would be deemed as a conflict-of-interest. It can't make markets. There may be ways around this, if two banks are involved in one transaction, but it makes the process much more cumbersome, if even possible.
No International Coordination
During conference, Republicans attempted to pass an amendment which would have required more international coordination before these new rules were adopted by U.S. banks. In particular, it would have required a majority of the G-20 nations go along before the rules take effect. Although some countries have indicated that they're open to Volcker rules of their own, there have been no firm commitments. Democrats rejected the amendment, seemingly unworried that American competitiveness could be threatened if other nations don't develop similar regulatory schemes.
It's hard to see how this conception of the Volcker rule does much of anything for financial stability, assuming you believe that a well-constructed Volcker rule would have. Banks can continue to engage in prop trading at approximately the same magnitude as they have in the past. But now, they may be even riskier with less skin in the game and/or more in-house trading.