July 09, 2012

The Volcker Rule, arguably the most controversial element of the Dodd-Frank financial reform package, is slated to go into effect in July. But experts say the J.P. Morgan debacle underscores just how difficult it will be for regulators to enforce the ban on proprietary trading, and just how far the industry still needs to go to contain risk.


Two years after Dodd-Frank became law, the financial reform package appears to be dying a slow death, and many experts suggest that the Volcker Rule — perhaps the most important and controversial aspect of financial reform — will never work. Advanced Trading's July digital issue looks at what, if anything, on Wall Street has changed since the credit crisis and examines the challenges regulators face in enforcing the ban on proprietary trading.

On the surface, the law appears to be a fairly straightforward throwback of sorts to the Depression-era Glass-Steagall Act: Banks that are holding federally insured deposits and have access to Federal Reserve funds are banned from making bets with their own capital. The provision is aimed squarely at preventing the type of multibillion-dollar losses that drove the government to bail out the sector nearly four years ago as the global financial crisis reached a crescendo.

Yet even before the bad trades by J.P. Morgan's "London Whale" came to light, it was clear that regulators were faced with a gargantuan task in determining how the Volcker Rule would function. In addition to the difficulty they'd have in distinguishing prop trading from everyday buying and selling of securities for customers, industry experts have argued, authorities also would need to be equipped with a mechanism that could track a banker's book to ensure that whatever positions the firm had taken were completely hedged.

Regulators Are at Banks' Mercy

But as evidenced by J.P. Morgan's $2 billion (and counting) loss from a hedging strategy gone wrong, that's easier said than done, according to Stephen Anikewich, the head of U.S. compliance for NICE Actimize, a financial crime, compliance and risk management solutions provider. "If you look at what happened with J.P. Morgan -- regulators live there on a day-to-day basis; they have to have a permanent shop there," he explains. "So they had all this transparency with respect to the activities going on in London, but even in that situation they weren't able to detect this. My gut tells me the regulators largely do nothing more than piggyback onto the risk systems that the firms developed internally."

[What Went Wrong With J.P. Morgan's $2 Billion Hedge?]

And if there happens to be a fault with the metrics being used by a bank, such as the Value-at-Risk (VAR) model that was deployed in the J.P. Morgan episode, there's not much that regulators can do, Anikewich cautions. "The regulators in many regards are going to be very dependent upon the systems that banks have and the data they're providing as it relates to their risk," he says. This suggests that rather than making their own independent assessments of whether a bank's activities are legally permissible under the Volcker Rule, regulators simply will be at the mercy of the data that's being given to them by the very participants they're supposed to be policing.

In addition to robust risk management systems, under the Volcker Rule, Anikewich points out, banks also must have tools to calculate whether they've crossed the line from lawful hedging and market-making activities to taking on the sorts of risks that are now prohibited. "One of the challenges the banks will have under the Volcker Rule is being able to have a structure in place to be able to draw the line of demarcation between their hedging and dealer market-making activities versus their risk activities," he adds. "I don't know that's necessarily a 'bright line' test. It's going to be a struggle for many of these firms to put the controls in place to effectively monitor that."