On December 10th, U.S. banking regulators released the long-awaited final version of the Volcker Rule. This piece of legislation – the main component of the Dodd-Frank Act – is meant to prevent firms from placing risky bets where only they stand to gain (i.e. proprietary trading). You know, like an investment bank selling securities to investors that are backed by risky home mortgages, while at the same time betting against the housing market – not that they’d ever do something like that…again.
You might be surprised to hear that we actually view the new regulations as a positive for our investments in the banking sector. Why are we positive? Well, first let me explain some of the impacts of the Volcker Rule to put our views in context.
The final text of the Volcker Rule has 892 pages of preamble and 71 pages of “Common Rules” – assuming you printed it double-sided, that’s about 4.8 pounds (2.2 kilos) of legislation. So I’ll spare you all the nitty-gritty details and just focus on some of the more salient points:
- Prohibits proprietary trading by allowing banks to participate in market making activities (buying securities from one investor with the intention of selling to another investor at some point) but restricting inventory levels from exceeding what is reasonably expected to meet near-term client needs. This rule effectively prevents firms from amassing positions that could be considered “proprietary trades”. Importantly, U.S. government, agency, state, municipal and foreign sovereign bonds were exempted from inventory restrictions in order to maintain liquidity in these important markets. Overall the rule came out better than some had feared as they were not restricted from carrying an inventory of securities and they were not limited to only fee and commission-based revenues.
- Banks aren’t allowed to compensate employees in a fashion that incentivizes proprietary trading.
- Banks are allowed to hedge specific risks, as long as they recalibrate the hedges so that they don’t become sizable enough to become outright bets. Previously, the market was concerned that banks would be restricted from hedging various risks. As a result, this rule was somewhat softer than expected.
- Banks aren’t allowed to acquire or maintain ownership interests in hedge funds, private equity funds, or commodity pools that exceed 3% of the ownership interest in each fund or exceed 3% of the bank’s capital.
- Banks aren’t allowed to engage in activities that would pose a material conflict of interest or material exposure to high-risk trading strategies or activities that pose a threat to safety and soundness.
- Increased regulatory scrutiny via on-site supervisors, who are tasked with assessing compliance with the Volcker Rule.
- These rules apply to U.S. banks and their foreign subs, while foreign banks are exempt as long as the transaction occurs outside of U.S. markets. Some are suggesting this places U.S. banks at a competitive disadvantage versus foreign banks that do not operate within the United States.
- CEOs are required to attest to Volcker Rule compliance.
So, now the question – given all this new regulation, why do we have a positive outlook for the banking sector? Sure, the sector will face revenue headwinds and higher compliance expenses that will pose challenges to growing profitability. However, new regulatory requirements are forcing banks to increase their loss-absorbing capital buffers and maintain high levels of liquidity on their balance sheets. Couple this with the Volcker Rule, which should lower risk-taking at the banks. And remember, we’re bondholders – the creditors of these banks. We’re ecstatic because we’re better protected than we’ve been in years. Sure, global banking regulators are more intent than ever to force bondholders to absorb losses in the event of a future bank failure. That said, as a result of all the additional protection that bondholders now have (i.e., higher capital, lower risk-taking, and higher liquidity), the probability of a bank failure has been reduced. Based on this lower probability of default, we continue to feel banks offer good risk-adjusted value to fixed income investors since valuations are still better than their historical norms.
While we feel the Volcker Rule makes bank bonds an attractive investment opportunity, the real test of the new regulations is whether they help steer the financial system away from a future financial crisis. And only time will tell how effective regulations like the Volcker Rule will be in their stated purpose of controlling risk-taking within our financial system.
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