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Volcker Rule comments: The good, the bad, and the ridiculous

February 29, 2012: 1:05 PM ET

More than 16,000 comments were filed to the SEC on the proposed Volcker Rule, but don't expect the debate to end just because the comment period is over.

By Moshe Silver, Hedgeye

paul_volcker

Paul Volcker

The Volcker Rule is scheduled to go into effect in July, just five months from now. This is good news for folks who want a Volcker Rule, but it may be even better news for folks who desperately do not want one.

That's because the rule is set to take effect even if the actual rule-making is still in progress. There will be a two-year transition period, and the Fed will have authority to grant one-year extensions on a case-by-case basis. In this context the words "in progress" may be an overstatement. The SEC has had far greater success banging their heads against the brick wall of Congressional contempt than obtaining the resources and support they need to do anything resembling market oversight.

The SEC closed the comment period for the Volcker Rule last week and now retires to begin crafting a final rule that will prevent Too Big To Fail financial institutions from jeopardizing the markets with wanton risk taking. The Volcker Rule is intended to fence off the banks' risk-seeking activities, ensuring taxpayers will not be on the hook for losses incurred in the course of speculative activities.

In his comment on the rule, former IMF chief economist Simon Johnson cautions that "the repeated pattern of 'cognitive capture' displayed by many regulators in recent decades" makes him "worry about the ability of major Wall Street firms to argue that they do not need close supervision." We think this the Most Dead On of comments, going to the heart of the fecal hurricane surrounding the rule.

We scrolled through a number of the comments in the SEC website and offer some excerpts, together with our own observations. The SEC says comment letters generally fall into three categories, which they call A, B and C.  We reprint sample Letter B in its entirety:

I'm writing in support of a strong Volcker Rule. My family and I were affected by the economic collapse of 2008, and we don't want it to happen again.

As you prepare the final rule, bear in mind the fundamental goal of the rule – to ban big banks from exposing consumers and taxpayers to risky proprietary trades.

Banks that break the rule should face swift, automatic penalties for violations. Violations of the Volcker Rule endanger the stability of our financial system. They should not be treated lightly.

Exemptions should only be allowed if they do not undermine this goal. If an exemption would result in exposing consumers and taxpayers to bank risk, it should be rejected.

Thank you for considering my comment.

Out of 16,488 tabulated comment letters, Letter B was typical of 15,838. Which way do you think the Commission will lean?

Unsurprisingly, industry entities and their lobbying groups are critical of the Volcker Rule. In a more unusual development, foreign regulatory agencies, central banks and governments have filed public letters highly critical of it.

MORE: Jamie Dimon: JPMorgan is still too small

The criticisms mostly come from the financial services industry. Firms and corporate groups primarily focus on increased costs to market operators, with what many claim will be reduced capacity for corporations and governments to access the financial markets. Some provide an analysis indicating the rule will increase bid-ask spreads by upwards of five basis points. We note market making firms have long complained that decimal spreads in equities have made market making unacceptably risky, so while issuers may end up paying more, Wall Street will no doubt figure out a way to make money off this. Some observers believe the final rule will respond with vague numbers, which will likely result in a legal challenge.

Professor Johnson takes this item head on. Referring to foreign sovereign issuers, he says "most participants in the market will be unaffected" by the Rule, and he challenges the methodology used in studies to demonstrate the Rule's negative impact on the markets. Still, he says, if foreign governments are adamant on US banks' being able to trade their debt at-risk, as they believe is necessary for sufficient liquidity, he suggests they indemnify the US to remove taxpayer risk. One might ask how a strong Volcker Rule is different than Germany refusing to take on the risks of Greek sovereign debt.

The letter from Credit Suisse argues that reduced liquidity in the US markets will lead to "the development of alternative trading platforms outside of the US," which is exactly what the global markets need. CS argues that this will "lead to job losses," not allowing that a job lost on Wall Street might equal a job created in Athens.

Adding their voices to the 16,000 or so who support the Volcker Rule, the Senators who wrote the thing – Carl Levin of Michigan and Jeff Merkley of Oregon – submitted a comment of their own, calling the SEC's proposal "tepid" and "focused on minimizing its own potential impact."

A thoughtful comment letter submitted by Robert Johnson of the Roosevelt Institute and Nobel Prize-winner Joseph Stiglitz says the perceived complexity of the Rule is "at best a reflection of the incredible complexity that banking itself has created, and a worst a reflection of the proposed rule's timidity" as it seeks to "implement a law that directs a reduction of trading by banks without reducing trading by banks." Johnson and Stiglitz open by saying "the American middle class and its economy have been the victim of three types of abuse by the financial industry: usury, bailouts, and prolonged tolerance of debt overhangs," all of which have robbed the economy, they say, of significant resources and greatly diminished its vitality.  "Banks," they write further down, "have taken refuge in complexity to extract massive margins and fees that generate bonuses."

MORE: Sorry, SEC. Fast trading on Wall Street is here to stay

Johnson and Stiglitz write that the Volcker Rule "mandates afundamental reconsideration of activities… that served only the bonuses of the bankers, put taxpayers at risk, and did not serve the real economy."  They quote studies that show the current financial system to be "less efficient than that of 1950 or even 1980" and draw a causal link between "record compensation for Wall Street traders" and the decline in real wages, the increased offshoring of jobs, and the shrinking middle class. "Trading volumes should not be mistaken for efficient capital markets or productive investments," they write.

A 325-page comment letter was submitted by "Occupy the SEC," a working group of member of the Occupy Wall Street General Assembly, a number of whom are attorneys or former Wall Street professionals, and whose analysis and comment shows they are anything but a fringe group. As you would expect, they articulate a strongly pro-regulation position, and they criticize what they perceive as weaknesses and loopholes in the rule.

"It is worth emphasizing that all major banking entities have had extensive compliance regimes in place for many years, and yet they did not prevent the various systematic failures that occurred in the 2008 financial crisis," says the Occupy letter. Practitioners of the art of compliance understand this all too well.

We have a few months to go before final implementation of the rule. Until then, we expect to hear some outlandish verbiage. We expect a number of outrageous changes to the Rule will be proposed, and a number of them will be implemented, further weakening regulatory oversight and strengthening the already-mighty banks.  We expect certain small victories as well, but on balance, we expect the Too Bigs will remain Too Big and, as we say in the neighborhood, the rest of us will pound salt.

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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