Federal financial regulatory agencies are fiddling while corporate financial executives burn as the clock winds down to the July 21, 2012 deadline for compliance with the Volcker Rule. That is the Dodd-Frank law provision which generally prohibits banks and some non-bank financial companies from engaging in proprietary trading or dabbling in hedge or private equity funds. Because Volcker handcuffs banks, the provision named for former Federal Reserve Board Chairman Paul Volcker could crimp corporate access to commercial debt underwriting, sweep accounts, commercial paper, and foreign exchange services. Companies with financial subsidiaries such as John Deere, Target, General Electric and Toyota could face an additional set of negative effects. Disclosures in May about JP Morgan's trading losses probably provided political cover to federal regulators who might have otherwise worried about tighter restrictions on banks igniting Republican and corporate opposition.
The five federal agencies involved in writing a final Volcker Rule moved to ease banking industry and corporate borrower concerns by announcing on April 19 that they were extending the "conformance period" for Volcker from July 21, 2012 to two years hence. But the announcement did nothing to allay concerns about the provisions in the proposed rules, many of them vilified by American business.
What exists, so far, are two, very similar proposed rules whose differences reflect the kinds of companies who will be directly affected in each case. The Federal Reserve Board, Comptroller of the Currency, Securities and Exchange Commission and Federal Deposit Insurance Corporation issued one proposed rule last November 7; the Commodities Future Trading Commission issued its in February 14. The CFTC comment period did not even close until April 16. Although the Fed is in the driver's seat in terms of adjusting any compliance deadlines, it actually will regulate the smallest group of businesses subject to the rule: non-bank broker-dealers affiliated with bank holding companies. The SEC will regulate broker dealers, the Comptroller will regulate national banks. Those last two groups will have the biggest impact on corporations looking for bond underwriting services.
The two proposed rules have dissatisfied almost everyone. The banks argue they are being restricted in areas which had nothing to do with the 2008 financial crisis. Labor unions and public interest groups say the proposed rules are too lax. Corporations say the proposals will shrink the credit and equity markets they rely on.
"The regulators have gone to some effort to preserve business as usual in important areas. This includes practices at the center of the financial crisis, such as dealing in illiquid and customized products for which no market exists and bank participation in securitizations," says Marcus Stanley, Policy Director, for Americans for Financial Reform, a coalition whose biggest names are the American Federation of Labor – Congress of Industrial Organizations (AFL-CIO) and the Federation of State Public Interest Research Groups (U.S. PIRG).
Organizations such as FEI, the U.S. Chamber of Commerce, the Business Roundtable, many individual companies and most of the hedge and private equity funds in the country take the opposite view. "The corporate bond market will be affected by the proposed Volcker Rule as financial dealers may be prohibited or deterred from taking on the inventory and risk associated with supporting and facilitating the market, creating new costs for investors and issuers alike," says Teri L. List-Stoll, Chair, Committee on Corporate Treasury, Financial Executives International. Her day job is Senior Vice President and Treasurer, Procter & Gamble. "Corporate issuers could be faced with higher yields on new debt if banking entities are restricted from serving as the market-makers for these debt securities." According to a recent study by Oliver Wyman, corporate issuers could be facing “$12 to $43 billion per annum in borrowing costs over time, as investors demand higher interest payments on the less liquid securities they hold."
Aside from facing higher interest payments, corporations could find that Volcker implementation forces banks to resist the sale of derivatives to companies who want to hedge operational risks. "As proposed, the Volcker Rule may restrict the ability of financial entities to take on the various transactions that non-financial companies seek to hedge their business risk," explains List-Stoll. "Risk mitigation is an important component to the corporate treasury function, but without a willing banking entity or counterparty to take on the transaction, the risk is left on the company’s balance sheet."
Opposition to the Volcker proposed rules has been so virulent and contagious that it has infected even congressional Democrats, most of whom supported the provision when it was passed nearly two years ago. At hearings at the Senate Banking Committee on March 22, Committee Chairman Sen. Tim Johnson (D-S.D.) said the Volcker Rule raises a number of complicated issues with potential international effects. "It is important to carefully implement the rule’s prohibitions on proprietary trading and fund investments in a manner that does not impair market making, underwriting, client services, hedging and other 'permitted activities' so important to our economy," he stated. " Market participants need greater clarity about the conformance period and what will be required of them starting this July."
The April 19 announcement from the five agencies didn't provide much clarity beyond an extension of the conformance period. Johnson and many others on the Hill, many of them supporters of Volcker generally, are worried that come July 21 the Volcker Rule will go into force with the extension of the conformance period but still leave banks and investment companies still unsure of what they can or cannot do. At the Banking Committee hearings, Daniel K. Tarullo, a member of the Board of Governors of the Federal Reserve System, tried to assuage committee members that the Fed would provide "clarifications" to the business community prior to July 21 if a final rule were not published by then, which Tarullo conceded is "a real possibility." Tarullo emphasized: "We should not let this hang out there as an unknown."
In a letter on March 28 to the heads of the five agencies writing the Volcker Rule, Mike Nicholas, Chief Executive Officer of the Bond Dealers of America, referred to Tarullo's promise of guidance. "The BDA hopes that this aspect of the guidance will recognize that there should be few, if any, obligations imposed on market participants during a two-year conformance period," he stated. "As July 21 draws closer, and in the absence of coordinated joint regulatory guidance regarding the obligations of market participants as mentioned above, the BDA fears that the marketplace will assume the worst. The result could be that our liquidity concerns become a self-fulfilling prophecy, even prior to the issuance of a final Volcker Rule."
There is considerable support, even from unlikely places, for the five agencies to take a second crack at a proposed rule. Rep. Barney Frank (D-MA), whose name is on the Dodd-Frank legislation, has asked the regulators to issue a "simplified" final rule by September 3, the implication being that they can issue a more detailed final rule later, after they have reconsidered all the negative comments they have received based on their first proposed rule. SEC Commissioners Dan Gallagher and Troy Paredes have explicitly backed a second proposed rule. Federal Reserve Bank of Richmond President Jeffrey Lacker delivered perhaps the biggest blow to the Volcker Rule in early April when he said it might be impossible to implement. In an interview with Bloomberg TV, Lacker drew more blood by pointing out what others have already said: that bank trading books were “kind of tangential” to the financial crisis of 2008-2009, when bank capital was eroded by losses on risky mortgages, many of them bundled into complex securities.
Congress's thinking in including the Volcker Rule in Dodd-Frank was that banks and banking entities which receive federal deposit insurance and benefit from access to the Federal Reserve discount window should not be able to use these government subsidies to further their own corporate, for want of a better term, "gambling." There has been a lot of criticism of this rational by groups and individuals who argue the 2008 financial meltdown owed nothing to reckless bank proprietary trading and everything to trading in mortgage securities and failures of federal home lending policies and agencies, such as Fannie Mae. Hal S. Scott, Director of the Committee on Capital Markets Regulation, says, "There is no evidence that short-term proprietary trading investments or hedge fund and private equity fund investments were the major source of losses during the credit crisis. The investment losses include portfolio investments in real estate backed securities, an activity, like lending, which can continue under the Volcker Rule."
The Volcker Rule, again, depending on how it is finally written, could affect U.S. corporations in multiple ways. That is because its reach is so broad, and its language leaves so much room for interpretation, which the five federal agencies have labored, unsuccessfully, to nail down. The Volcker Rule imposes two significant prohibitions on banking entities and their affiliates: no proprietary trading and no investments in hedge and private equity funds. Opposition to the generally-aligned two proposed rules centers not so much on those prohibitions--even though many felt the restrictions were misplaced--but rather the difficulties banks would have in engaging in “permitted activities” such as underwriting, market making, and trading in certain government obligations. Volcker exempts these from its reach, but also establishes limitations on those excepted activities.
The biggest corporate concern is that Volcker will force big banks and financial firms to retreat from the corporate bond market. David Hirschmann, President and Chief Executive Officer of the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness, concedes that the Volcker Rule proposal issued by the federal agencies does specify that underwriting for commercial paper falls under the exemption for market making-related activities. And it does exempt market making for commercial paper from some of the Volcker Rule proposal's requirements. "But that exemption is insufficient," he adds. "Balancing entities still must meet the other requirements that unduly limit market making activities. They are burdensome and arbitrary."
The definition in the proposed rule of "covered funds"--the hedge and private equity funds banks cannot invest in or retain an ownership interest in-- is broad and could inadvertently sweep in many commonly held corporate structures that are used for capital formation and risk mitigation, such as wholly owned subsidiaries and joint ventures. The covered fund definition could also sweep in venture capital investing, which is contrary to congressional intent.
The proposed rules allow banks to invest in or run covered funds in some instances; but as one might expect, the ground rules there depend on all sorts of interpretations that are as stretchable as taffy. For example, a bank can organize a covered fund, or serve as a general partner or trustee, if it provides bona fide trust, fiduciary or investment advisory services as part of the business, and that the fund is offered only in connection with such services and only to customers of such services. There are other requirements, too.
In the absence of a final Volcker Rule, and during the extended conformance period, banks may think twice about financial services they offer to corporations. Even when the final rule is published, banks will likely need a GPS to navigate its provisions. So traffic patterns between corporate CFOs, treasurers and other financial executives and their bankers may change, and not for the better, necessarily, unless the provisions in the proposed rule are significantly refined.