The background to the Volcker rule | FT Alphaville

The background to the Volcker rule

Because background briefings for the media are fun, and interesting, and something that the public don’t often get to see, here’s the transcript of the press rundown for the Volcker rule unveiled last week.

Things to watch out for — “senior administration officials” dodging any outright mention of Goldman Sachs, and the explicit statement that this is about “constraining future growth” of the financial sector.

But we’ve highlighted the best bits for you anyway:



Via Conference Call

10:12 A.M. EST

MS. PSAKI: Good morning, everyone. Thanks for joining. I just wanted to remind everyone that this is on background. You can attribute anything that’s said on this call to senior administration officials. And it’s embargoed for the start of the event at 11:40 a.m. this morning.

We also hope to have a press release out shortly, as well as the President’s remarks, so those might be right before the event.

SENIOR ADMINSTRATION OFFICIAL: Thank you all very much for joining us this morning. As you know, the President has been fighting for financial reform since coming into office. The administration put forward a strong and comprehensive financial reform package to the Hill.

We’ve been working closely with the Congress to get that enacted under the leadership of Chairman Frank and Chairman Dodd. Chairman Frank’s bill has passed the House. I know Chairman Dodd is working hard to get a strong bill accomplished in the Senate. The financial reform package we put forward includes core reforms to our financial system — reforms to protect consumers with a new consumer financial protection agency; reforms to regulate over-the-counter derivatives markets and other financial markets that have been outside the purview of regulation and that helped to contribute to the crisis; reforms to the supervision of big financial firms to ensure that we have comprehensive, consolidated supervision, high capital standards, liquidity requirements, activity restrictions, and other measures to limit the risky activities of financial firms.

We have core reforms to be sure that we have a robust infrastructure in our financial markets to prevent and limit financial panics. And we have a set of reforms that are really designed, at their core, to prevent risky practices from building up in financial firms, to have bigger buffers in the system, higher capital requirements in the event of failure, and a new resolution authority to be sure that we can wind down big firms without causing the enormous damage that we’ve seen to the economy in the last financial crisis.

As part of that package of reforms, we’ve been working with the Congress to ensure that regulators have the appropriate authority to limit conflicts of interest between banks and their activities in proprietary trading and hedge funds, that regulators have the authority to break apart large firms, to limit their risky activities in the event that they pose a threat to financial stability.

And today’s two additional reforms are consistent with that set of reforms Chairman Frank and Chairman Dodd have been pursuing. They are designed to further reduce the potential risk in our system and to prevent further concentration in our financial system. And I want to turn it over to my colleague to describe one of those reforms, I’ll describe the other one, and then we’ll open it up to further questions.

SENIOR ADMINSTRATION OFFICIAL: Thanks. The first of those reforms is a limit on the scope of activities that banks, bank-holding companies and financial institutions that own banks can engage in. It’s quite important as a background measure that this is a piece of the broader reform that my colleague was talking about, because it’s critical that we deal with “too big to fail” institutions, that we have resolution authority and things of that nature regardless of how we try to limit the riskiness of activities of banks. What this proposal specifically would do is use the broad authority that’s outlined in the House bill for regulators to prevent the banks, commercial banks, from owning, investing in or advising hedge funds; owning, investing in or providing advisory service to private equity funds; and limiting the proprietary trading that they do for their own account — that is for their own profits — that is not related to their client business. So it moves them more to identifying their core business as being something like serving their clients.

As a timeline of this, as you know, Chairman Volcker is the Chairman of the President’s Economic Recovery Advisory Board. The PERAB, as it’s known, has been thinking about a lot of these issues for a long time. And the administration in its white paper in June, as well as in its internal deliberations, has been thinking about these issues about reducing risky activities for major financial institutions for some time. Tim and Larry have been in frequent contact with Chairman Volcker, with other members of the PERAB. Over the fall the President met with

Chairman Volcker, and we’ve had a lot of discussions thinking about this issue. And we have come out of the crisis and seen major financial institutions who got special protections during the crisis turn around and make significant profits on their proprietary trading, really using the safety net to do that. It persuaded the President and the economic team that it was worth looking into this in some — outlining it in some more detail.

So that’s the — so the first rule to restrict risky behavior and activity that we outlined is this rule on proprietary trading. And the second I’ll turn to — turn back over to my colleague to talk about the scale.

SENIOR ADMINISTRATION OFFICIAL: So as my colleague suggested, the first is really an aspect of our activities restriction approach, approach to risky activities.

The second basic approach is to address questions about the future contours of our financial sector, and it’s a limitation on the size of any one financial firm in relation to the whole financial sector. We want to be sure that in the future, going forward, financial firms don’t become overly concentrated in the financial sector, is a way of updating what is an existing provision in the law. We have today a 10 percent cap on the share of insured deposits that can be held by any one banking firm. We believed it was appropriate to update that limitation to the broader range of financial firms now operating in our financial sector, and to take into account the non-deposit funding that major financial firms use increasingly over time.

And what we want to be sure is that we have a system in place that doesn’t improperly incentivize non-depository leverage in our major firms, that reduces the ability in the future for there to be excessive concentration in our financial sector. And this is consistent with the announcement we made last week designing our fee, our financial fee for the repayment of taxpayer funds under the Troubled Asset Relief Program.

We designed a financial fee that was focused on the non-deposit liabilities of financial institutions as a further disincentive to grow excessively in leverage, particularly in risky leverage over time.

So these are a series of steps we’re taking on the path to financial reform. Chairman Frank, as I mentioned, has a strong bill he was able to get passed in the House. Chairman Dodd and Senator Shelby I know are engaged in ongoing intensive discussions to achieve a reform bill in the Senate. And we look forward to working with the Congress on these proposals in the coming days and weeks.


Q I’m wondering why these proposals were not included in the comprehensive legislation you proposed in June. Already the House has acted; these provisions are not in the House bill. You’re going to have to go back now as part of the process. Why now? Why not back in June?

SENIOR ADMINISTRATION OFFICIAL: As you know, Jim, in June in our white paper, we talked about making sure we limited the activities of risky firms, and being sure that we address conflicts with respect to proprietary trading and hedge funds.

The basic authority is provided in Chairman Frank’s legislation, for regulators to break apart major financial firms or to address problems with risky activities to the extent that they cause the firm to act in an unsafe or unsound manner that threatens the financial system. So we worked very closely with Chairman Frank on that already.

What we’re doing today is making clear that as an aspect of that reform, not only regulators should have the authority, but they should be required to prohibit at least one form of activity that we’re especially focused on today, and that’s proprietary trading by banks, that benefit from safety net and are engaged in activities that are not related to their clients’ and customers’ activities.

So this is an aspect of that overall reform. The underlying authority is in the legislation, strong legislation, that Chairman Frank passed. What we’re doing today is saying regulators not only have the discretion to do that, they need to do that.

Q Thank you. Can I just be clear that this is targeted at investment — sorry, commercial banks who run investment bank-type operations? Will investment banks like Goldman, for example, still be able to advise and hold stakes in hedge funds?

SENIOR ADMINISTRATION OFFICIAL: So just to be clear, this prohibition says you can choose to engage in proprietary trading or you can choose to own a bank, but you can’t do both. You have to make the basic choice: Are you going to be a firm that does proprietary trading for your own benefit, unrelated to client interest, or are you going to be a bank that engages in those activities that are authorized? So it’s not the broader question that you raised. It’s really focused on the question of proprietary trading.

Q Thank you. I’d like to follow up on what your colleague said about Chairman Volcker’s role. I’m just wondering, Chairman Volcker has been very outspoken about his concerns about “too big to fail.” And I was wondering if you could talk a little bit more about the meetings that he’s had with the President and his influence in helping to underscore this issue. And also, it’s been reported that Chairman Volcker has been trying to get support for these ideas from people like Roger Altman. Is that true?

SENIOR ADMINISTRATION OFFICIAL: Well, let me start with the beginning. I’m not privy to the second question at all. On the first, Chairman Volcker and the administration are in total agreement on the issues of “too big to fail,” of the importance of changing the system to get away from the kind of structure that existed before where there was an implicit safety net that people were taking advantage of, and the importance of fundamental reform. I believe that there is wide agreement on all of the major points.

And Chairman Volcker will be at the announcement today. I think he — this is an issue that Chairman Volcker, the group of 30 — that he’s been concerned about for some time. He’s conveyed that and had many discussions with Tim and with Larry, as well as with the President and the economic team. So I would say he definitely has played an important advisory role as a member of the PERAB and his concerns on this, but this was an important decision where I think everybody was on the same page.

Q Hi, thanks for doing this. I’m just looking back at a quote from Diana Farrell from last October, which wasn’t that long ago. She talked about the big banks and she said we’ve created them, we’ve sort of — we’re sort of past that point, and I think that in some sense the genie is out of the bottle and what we need to do is manage them and oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to. I mean, it seems like you guys are erecting walls that are going back to the time, at least, as we were told, the spirit of Glass-Steagall. And I’m wondering what changed in your thinking here.

SENIOR ADMINISTRATION OFFICIAL: So I just want to be clear on this. We’re not returning to Glass-Steagall. This is about making sure that firms that own banks aren’t doing trading for their own account, not for the benefit of their customer, and benefiting from taxpayer subsidies through deposit insurance and the discount window access.

So it’s not about investment banks and commercial banks, and it’s not about returning to some long day of the past. This is an issue about in the range of activities that we’re undertaking to limit risks in the biggest firms, including tough supervision of those firms, higher capital requirements, liquidity restrictions, stronger firewalls, and a set of reforms on activity restrictions — all of which we’ve laid out clearly in our proposal and Chairman Frank has gotten through the House of Representatives in very, very strong form.

We’re saying as part of that we want to be sure an aspect of the activity restrictions that are authorized are actually undertaken, and that’s with respect to this area of proprietary trading. And as my colleague suggested earlier, one of the reasons we think that’s important is that if you look back over the last year I think you do see that a number of firms that are engaged in proprietary trading and have benefited from the safety net, their activities have stepped up over this last year in ways that made it clear to us that we should focus on this aspect of our proposal, make sure that regulators not only have the authority to address this kind of practice, but are also essentially required to do so.

So it’s fundamentally different from the question about whether commercial banks and investment banks should be part of the same holding company.

Q I have a follow-up to something earlier where you said that these authorities are included in the Frank bill. So there would be no additional legislation beyond what that is for this to take effect. So is there some official rulemaking or some directive the President has to make, or is this just a statement saying regulators should do this?

SENIOR ADMINISTRATION OFFICIAL: No, no, I’m sorry. I want to be clear. We want to put in the legislation — there’s legislative authority, there’s discretion for the regulators to take on risky activities with respect to the largest financial firms. We want to take legislative steps. We will ask Chairman Dodd and Chairman Frank to supplement what is already in their bills with legislative steps that don’t just authorize but actually require regulators to prohibit one form of that risky activity, and that’s proprietary trading by firms that own banks. So it is a legislative step. It is moving what is a discretionary authority that Chairman Frank provides in his bill to a requirement on the regulators to act in this particular area where we have a special kind of concern.

Q Thanks very much. If I may, a very quick clarification and a question. The clarification is, could an entity still have access to the discount window but not have any deposits and be allowed to engage in prop trading, or would you have to give up access to the discount window as well as insure deposits in order to continue with prop trading?

And secondly, can you just talk a little bit about the other restrictions you mentioned in terms of hedge funds and private equity? Just flesh that out a bit for us.

SENIOR ADMINISTRATION OFFICIAL: Sure. So with respect to discount window access, discount window access is in our proposal confined to institutions that own depository institutions. There is no discount window access for other kinds of firms, even if those firms are, as they should be, subject to consolidated comprehensive supervision. So this is really about what banks and firms that own banks are allowed to do. It’s part of our broader overall comprehensive plan that says if you are a big financial firm that could pose risk to our financial system, if you’re so large and interconnected and leveraged that you could threaten our basic economy, as we saw firms do in the past, you’re going to be subject to comprehensive supervision and regulation, whether or not you own a bank. Even if you don’t own a bank you’re going to be subject to tough new rules. You’re going to have higher capital requirements; you’re going to have higher liquidity requirements; you’re going to have activity restrictions; you’re going to have consolidated supervision by a tough regulator. You can’t escape the basic form of regulation by changing your corporate form. That is absolutely core to our set of proposals.

Q A question about the size — limitations in the size of the banks. Is the 10 percent cap on the share of insured deposits, is that replacing a prior figure?

SENIOR ADMINISTRATION OFFICIAL: The 10 percent cap on insured deposits exists in current law. It was put in place in 1994. And what we’re saying is that deposit cap has served or country well. It needs to be updated and supplemented with a cap on other forms of funding — non-deposit funding, other forms of liabilities — so that in addition to the deposit cap there should be a cap on these other forms of liabilities with respect to the share that that institution holds in the economy. So it’s saying the deposit cap is good but it needs to be extended to this new realm.

Q Hi, thank you. Just wanted to know more how could this — practically, how would this work day to day? I mean, what would the regulators do? How do they decide when to do this? Can you just lay out how it practically works?

SENIOR ADMINISTRATION OFFICIAL: Sure. So as you know, there are rules on that under the existing deposit cap. There would be similar rules like that going forward for this proposal. We’re going to work very closely with Chairman Dodd and Chairman Frank on the specifics of the rule, and then obviously the regulators will need to define further from there. But the same kinds of basic approaches that are used today could be used with respect to the new approach that the President is going to be discussing later this morning.

Q Hi. I was wondering, could you just give me a practical – I mean, do you know how big the 10 percent cap would be now in terms of what it would apply — I mean, how big a bank are we talking about here? And also, I mean, you’re doing this on the day that Goldman Sachs earnings are out. You’ve talked about proprietary trading. Is this directly related to Goldman? Because you mentioned banks that have seen their proprietary trading grow.

SENIOR ADMINISTRATION OFFICIAL: So I’m sorry, I couldn’t hear all of the last part of your question, but I’ll address at least the first part and some of the second.

So with respect to the deposit cap, let me be clear that we’re not saying that the new liability cap will be 10 percent. That’s something that we’re going to need to work with the regulators on to be sure we refine; work with Congressman — with Chairman Frank and with Senator Dodd to refine. The liability cap will be structured in such a way that it constrains future growth that leads to excessive concentration in our financial system. It’s not designed to reduce the share of any existing firm.

It’s designed to make sure that we don’t end up with a system that some other countries have in the world, in which there’s enormous concentration in their financial sector. So it’s designed to constrain future growth. It’s not about reducing liabilities within — the share within the existing structure.

And just to be clear, this, again, is part of our comprehensive set of proposals to constrain risky behavior by the largest financial firms.

It’s not the answer to financial reform; it’s part of a comprehensive package of reforms that we’ve put forward. I think the second part of your question was related to earnings announcements at particular firms, and today’s event has literally nothing to do with that.

Q I was wondering, first, about how many institutions you expect this to affect directly, and if the administration has discussed it with the leaders of those institutions, and how those conversations went.

SENIOR ADMINISTRATION OFFICIAL: We haven’t, to my knowledge, discussed it with the leaders of any financial institutions. It’s something that we’ve developed here in the administration, that we’ve worked with the President’s Economic Recovery Board on, and it’s part of our comprehensive reform plan.

In terms of the institutions it will affect, obviously the largest financial institutions in the country have more activity that could be described as proprietary, and also have much larger shares of our financial sector market, as they do today. And so the overwhelming bulk of the focus of these initiatives, consistent with our reform efforts, are about the risk in the system posed by the largest financial firms in the economy.

SENIOR ADMINISTRATION OFFICIAL: And I would say, as you know and as we’ve said many times, the administration, in developing all of this broad regulatory reform, has talked to consumer leaders, financial leaders, ordinary citizens, members of Congress — really anyone with ideas. We’ve talked to everyone. So I don’t think that’s a surprise.

Q Why would separating proprietary trading operations convince anybody that those units wouldn’t have access to the safety net? Bear Stearns had access. AIG had access. And you guys have also insured Fannie Mae and Freddie Mac. None of these institutions had access to the discount window.

SENIOR ADMINISTRATION OFFICIAL: All of that looks at a time when there was no comprehensive regulatory reform effort. I mean, I think what my colleague said at the outset he said for a reason, which was this is a part of a comprehensive effort where we must have resolution authority, we must end “too big to fail,” we must take all of the steps to rein in the risks of contagion and systemic risk that plagued us in this crisis. So there’s no doubt that in the last crisis we just went through there were a whole bunch of entities that were of forms that were perceived as too big to fail and threatened the system with their collapse, and that’s exactly what we’re trying to end.

If you were only doing these two reforms today and that was your only regulatory reform plan, that would be very problematic. But this is one component of a broad effort that we’ve described in other places.

Q Hi, everyone. I actually had a couple questioners cover my ground, but I would like to go back to the idea that, you know, why now. Why not come out with this before the House had embarked on its bill and Mr. Kanjorski added his language?

SENIOR ADMINISTRATION OFFICIAL: I think that if you go back again and look at the course of the reform effort we’ve been engaged in, in the June white paper we highlighted the basic issues involved here. In our legislation we sent up to the Hill we were focused on basic risks in the system, the core issues of constraining excessive leverage, the core issues of constraining excessive risk-taking in our system. We worked very closely with Chairman Frank in October to put in a provision that gave explicit authority to the bank regulators to break apart large financial firms, to stop them from engaging in risky activities if it threatened the system. In December we worked very closely with Chairman

Kanjorski to be sure his amendment to strengthen that core provision gave the regulators the tools they needed to break apart large firms or to prevent risky activities in the event they threaten the system. And today what we’re saying is as part of that effort we want to be sure that the regulators are not only authorized to take that step, but with respect to proprietary trading that they’re required to do so. And

I think my colleague pointed out and I reiterated that I think the practices of the largest financial firms over the last six months, eight months, have reinforced our concern in this area and led us to want to be sure that this activity is covered in this manner going forward.

Q Hi, guys. Thanks again for doing this. Just to clarify then, is there some judgment and leeway then for the regulators as they look over proprietary trading operations, that they would then decide that if it was too risky and if it posed a risk to the financial system then they could shut down those proprietary trading operations, or would the companies then perhaps, say, be required to spin them off as we saw with JP Morgan back when Glass-Steagall was first implemented?

SENIOR ADMINISTRATION OFFICIAL: So I think — just to be clear, there’s two separate provisions. So the provision the President is talking about today, the additional legislative step, would require the regulators to stop the firm from engaging in proprietary trading if they also owned a bank. In addition to that, the regulators have additional authorities that are in our proposal and Chairman Frank’s legislation that if there are other risky activities that the firm is engaged in, whether or not they own a bank, authority to prohibit or to require it to be spun off.

So both those authorities are part of our overall reform, together with tough supervision of the largest firms, again, whether or not they own a bank, new resolution authority to wind down the major firms without causing a financial panic, a key concern to make sure consumers are protected in the future with a new consumer financial protection agency, comprehensive regulation of the over-the-counter derivatives markets, hedge fund securitization. So this is part of a wide, sweeping set of reforms the President has put forward that have already passed the House of Representatives and that we’re working really closely to get done in the Senate.

SENIOR ADMINISTRATION OFFICIAL: And what I would say is normally if you envision how is this happening, the key thing is, is the trading related to your client or client business? And so the regulator would look and say, “Hey, these positions you’re taking — how is that related to client business?” And if the answer was, “It’s not,” then the regulator would say, “Get out of those positions.”

Q Hi. I’m still a little confused about how these size limits are going to work. I’m wondering how — is this total liabilities — total liabilities in the U.S. economy? Is it like market-by-market, different kinds of debt? And I’m wondering if you could just walk me through how that might have prevented something like a Lehman.

SENIOR ADMINISTRATION OFFICIAL: Sure. So with respect to – with respect to the way it’ll work, under our system today there’s a cap on deposits that prevents future acquisitions by a firm if they’re up against that cap or if the acquisition would place them over the cap. We’re going to need to develop strong rules with respect to other sources of funding.

As with our financial fee that we announced last week, which is based on liabilities of the firm, we’re going to be working very closely with the Congress and with the regulators to develop a strong, tough rule not subject to evasion, not subject to off-balance-sheet movement that might affect the basic form of the financial fee or in this case the basic form of the scale restrictions. It’s designed to prevent future concentration, excessive concentration, in our financial system.

And we’re going to be working very closely with the Congress on the details of that.

Now, this is not, as I mentioned at the outset, the whole answer to ending “too big to fail” or basic reforms of our system. As we’ve said all along, and I reiterated this morning, this is part of a comprehensive package of reforms that we have put forward, that Chairman Frank has championed and successfully gotten enacted in the House, that Chairman Dodd is working with Senator Shelby in the Senate. It’s part of tough new rules on the largest firms, whether or not they own a bank; comprehensive consolidated supervision. You can’t have a firm like Lehman or Bear Stearns outside the basic framework of comprehensive consolidated supervision. They can’t escape appropriate supervision by changing their corporate form, whether or not they own a bank.

It’s part of that tough rule that if you are in the system, you’re going to be subject to tough new capital requirements, tough new liquidity requirements, activities restrictions, heightened firewalls, and real buffers in the system, together with the authority to wind down those big firms without causing a financial panic that harms the economy.

So this is part of that overall comprehensive reform precisely to deal with Lehman and Bear Stearns and AIG and other firms that caused so much damage to the economy when they collapsed.

Q I apologize if this is a dense question, but based on what you said before about restricting future growth as opposed to constraining the current concentration, is that an indication that you think the current distribution of the financial sector and concentration is not a problem as it currently stands but that growing larger would — or more concentrated would be a problem?

SENIOR ADMINISTRATION OFFICIAL: The focus really is on making sure that in the future that firms don’t grow so concentrated that they would exceed this kind of cap overall on sources of funding. It’s designed to constrain future growth so that we don’t have the extent of concentration you see in many other major advanced countries in the world that were — resulted in way more devastating damage to those countries during the financial crisis even than occurred here in the United States. So it is an extra protection on top of the other reforms we’re proposing to limit the problem of “too big to fail” and harm to our financial system.

Q I was wondering if you could explain a little more why you’re targeting proprietary trading. Is it strictly an issue of risk or is it your concern over conflicts of interest or what exactly is the thinking there?

SENIOR ADMINISTRATION OFFICIAL: Well, I would say there were two main lines of thinking. The first, in addition to — we know it is risky and tends to be leveraged, but the two issues are, one, there is a conflict of interest frequently between the companies doing trading — the financial firm doing trading and the interests of their clients, but more importantly, as my colleague said and as I said, these financial firms that own banks or banks themselves have access to the discount window in a moment of crisis through the Fed. They have federal deposit insurance. We take a series of government-sponsored supports. And so it’s inappropriate for them to be doing proprietary trading for their own benefit — that is for their own profit, as opposed to for a client.

So it’s not against the activity of trading itself; it’s that they’re doing a thing that is putting money in their own bottom line, using inappropriately this support they’re getting from the taxpayer.

Q Hi, guys. Thanks for doing this. A lot of my questions have been answered. But I wonder if you’re concerned whether, in regards to the trading with hedge funds and investments in hedge funds and private equity, whether some of these firms will find a way around those rules through setting up SPVs or other mechanisms. Can you address your concerns over that and maybe flesh out exactly how that’s going to play out practically on the ground?

SENIOR ADMINISTRATION OFFICIAL: So, David, I think these are a set of issues we’re going to be working on with Chairman Frank, Chairman Dodd and the regulators. We obviously recognize the issue. We want to be sure that both as to this set of proposals today as well as our comprehensive proposals, that there’s strong anti-evasion provisions, that regulators are given the authority they need to implement the rule. There’s, as you know, been enormous movement on the accounting side to consolidate off-balance-sheet vehicles already. That will help in this regard, but it doesn’t entirely address the issues that get raised in these proposals, and we’ll be working to be sure that, again, tough anti-evasion rules are in place.

Q Hi, two very quick questions. For firms that are in the business of making markets in particular areas, they will still be allowed to take positions that are essentially for their own account — that’s the first question.

SENIOR ADMINISTRATION OFFICIAL: I’m not sure whether the technology here will allow you to do your follow-up, but the answer to the first question is, yes, firms will still be able to make markets.

That’s related to doing services for their customers. So what they won’t be able to do is do proprietary trading for their own account unrelated to customer business. They will still be able to do important activities that are central to their role as financial intermediaries serving their clients.

MS. PSAKI: Thank you, everyone, for joining the call. We will have the remarks and the press release out shortly. And the event, again, is at 11:40 a.m. this morning. Just a reminder, this call is on background, attributed to senior administration officials and embargoed until the start of the event.

Thanks, everyone, for joining.

END 10:47 A.M. EST

Related links:
The bank problem in a single chart – FT Alphaville
The market-maker problem – FT Alphaville
What is proprietary trading? – Bronte Capital