By Lucia Santini, CFA
From the Summer 2012 Edition of Values
JPMorgan’s recent headline-grabbing $2+ billion loss on certain derivatives trades, alternately referred to as “hedges” by management and “bets” by politicians and others convinced of the need to curtail such activities, has again riveted policy makers on the byzantine world of financial regulation. The news broke just as regulators began to grapple with more than 17,000 public comments and an unprecedented international lobbying effort in response to their proposed implementation of the Volcker Rule (explained below). Foreign countries and international regulators alike fear the impact that strict rules may have on already strained market liquidity. JPMorgan, long the darling of the industry, had previously navigated these treacherous waters successfully, thanks to its consistently smarter-than-average hedges. But its loss, which some analysts predict will eventually top $6 billion, has inflamed the battle on the future of financial market reforms.
Just as we often hear wildly different interpretations of the daily news from the MSNBC and Fox News networks, there are sharply divergent views of financial reforms already in place, as well as critical developing reforms such as the Volcker Rule that have yetto be implemented. As we approach the fourth anniversary of the failure of Lehman Brothers and the near collapse of our financial system, fundamental questions remain: Are these derivatives hedges or bets, and what is their place in our financial system?
Former Fed Chairman Alan Greenspan popularized the view that derivatives redistributed risk, making the financial system safer. The experience from 2008 to date has proven otherwise. Many now believe that total system risk is unchanged. Even more troubling, it has been persuasively argued that a false sense of security provided by the “hedge” may encourage more perilous risk-taking. The largest financial institutions, such as American International Group (AIG) and JPMorgan, were considered to be best suited to assume the risk of “market makers”—firms that would stand ready to purchase or sell securities when other market participants sought to speculate or hedge. The collapse, or near-collapse, of such major financial institutions brought this whole system into doubt. Could it be that the market makers themselves were in fact speculating rather than hedging? With so many market participants depending upon these firms to hedge other investments, how could the system function if the guarantees they provided proved illusory?
The Volcker Rule—named for Paul Volcker, Greenspan’s esteemed predecessor renowned for his relentless assault on inflation—was introduced with the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. It was intended to limit systemic risks posed by bank hedging and investing activities through restrictions on proprietary trading and investment activity in private equity, hedge funds, and the like; and through clear, consistent, and continuous record-keeping and reporting.
It is no surprise that legions of lobbyists, consultants, and think tanks employed or supported by financial services firms seek to remind politicians and the populace of what those who remember their Economics 101 certainly understand: Well-functioning, orderly, liquid financial markets have provided a critical underpinning to sustained economic growth and stable societies. Strong and efficient capital markets allow the savings accumulated by individuals, corporations, and governments to support productive enterprises and projects, which are the engines of economic growth and development. The central questions remain. Will the imposition of the planned regulations stifle the markets and curtail growth, or will they enhance market confidence and encourage the development of a sounder financial system, less prone to periodic collapse? What sort of regulatory approach will balance the need to funnel savings to investments against the goal of limiting systemic risk?
Prior to the financial crisis, pundits and practitioners across the political spectrum bemoaned the complex, overlapping, competing, and sometimes conflicting structure of financial regulations that had developed over two centuries of our nation’s history. The most salient features of the regulations—Glass-Steagall, Federal Reserve Act, and Federal Deposit Insurance Corporation (FDIC)—were developed in response to earlier financial crises and panics that threatened societal stability and disrupted economic development. While each piece of this regulatory environment had its purpose, the need to streamline and strengthen the regulatory morass was self-evident well before 2008. Regrettably, the response to the most recent crises, like those that came before, has largely been to add appendages to an already unwieldy system. The legislation lacks the bold vision to reinvent the system in an efficient, integrated, and cogent fashion.
The four cornerstones of Dodd-Frank are the Consumer Financial Protection Bureau (CFPB); enhanced capital and liquidity requirements; the identification of systemically important financial institutions (SIFIs), both banks and nonbanks, along with a strategy for their orderly liquidation should it become necessary; and the Volcker Rule. These are designed to prevent recurrence of the most abhorrent and egregious activities and outcomes of the financial crisis of 2008. How likely are they to achieve their desired risk mitigation without snuffing out economic growth? It appears the jury will be out for quite some time.
Thus far, only the capital and liquidity requirements have been fully articulated and set in motion. Although even this cornerstone of reform was not without controversy, it gained support in part due to the phased approach that appeared to prevent the enhanced requirements from impeding near-term economic development. The final phase of these requirements does not become effective until 2016, leaving plenty of time for compliance as well as further extensions.
It will likely be many years and, with luck, many decades before another crisis permits an assessment of the effectiveness of the CFPB or the SIFI rules. Until then, the debate will likely rage on, pitting free-market conservatives against sustainable growth liberals who see a bigger role for regulation to reduce the excesses seemingly inherent in financial markets.
The final regulations for implementation of the Volcker Rule may not be determined and made known for many months. In one corner are the pro-stability, anti-risk forces armed with the recent JPMorgan fiasco. In the other are the free-market, pro-growth forces who point to the fragile global economic situation to defend the status quo. Who will prevail? The regulators must carefully balance the greater goods of promoting economic growth and limiting risk in the financial system, without regard to the many and varied entrenched interests. If the current state of political affairs is a clue, we should not expect final implementation rules to be published until we are into the next administration.
The final rules must help avoid precisely the type of calamitous excesses that threatened to bring down the global financial system recently—AIG’s “hedging” and its domino effect, the $7.2 billion in losses caused by a rogue trader at Société Générale, and most recently, the leviathan risk-taker dubbed “the London whale” at JPMorgan. Regulators must craft rules that have the power to prevent the use of government insured deposits to support the activities of traders and business models that suit the greed and self-interest of a few, rather than the safety and soundness of the system for the many. This may seem easy in principle. In practice, the complexity of the markets and derivatives is such that, unless market making is once again prohibited, regulators must consider unique factors and features for each of the markets affected: stocks, bonds, commodities, derivatives, and exchange traded funds. The magnitude and influence of the lobbying efforts for financial services organizations must be recognized and neutralized. Politicians and the public must refocus the rule-makers on their critical mission.