"The steeping Indian economic situation, global financial disasters and the rapid fraudulent activities have essentially lowered the faith of the investors in the financial sector. The merits and demerits of the Volcker Rule have been analysed by the regulators from time to time and hopefully the end result would help reinstate investors’ trust in the market."Post the 2008 financial...
"The steeping Indian economic situation, global financial disasters and the rapid fraudulent activities have essentially lowered the faith of the investors in the financial sector. The merits and demerits of the Volcker Rule have been analysed by the regulators from time to time and hopefully the end result would help reinstate investors’ trust in the market."
Post the 2008 financial crisis, myriad hypotheses are being bandied around by ‘experts’ to identify the root cause of the colossal breakdown in the global financial system and prevent its recurrence. The legislators in the United States availed the opportunity to revamp the existing financial system and build a stronger financial system. The consensus that emerged amongst most market participants is that the crisis occurred due to excessive risk-taking by banks. In order to prevent such a crisis from occurring again, the “Volcker Rule” (named after the chief architect of this model, Paul Volcker) was introduced as part of the Dodd Frank Act.
This rule is based on the premise that speculative trading activities by banks and financial institutions partly contributed to the financial crisis. The Volcker Rule was endorsed in January 2010 by the Obama Administration. Predictably, this led to heated discussions, criticisms and strident opposition from banks and other financial institutions. Pending issuance of final guidelines, which are expected by the end of 2012, recent trading losses by a major American bank have reignited the debate on the merits and demerits of the Volcker Rule.
The Dodd Frank Bill proposed prohibition on proprietary trading by financial institutions including banks and their affiliates subject to limited exceptions. These entities were restricted from owning, sponsoring or investing in hedge funds or private equity funds (as envisaged under the Volcker Rule). Proprietary trading has been defined as, engaging, as principal, for the trading account of the banking entity or non-bank financial company in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the appropriate federal agencies may determine. The Volcker Rule seeks to prevent losses on such proprietary trades/investments which in turn reduce banks’ ability to lend.
Evidently, the Volcker Rule does create an issue with respect to treading the fine line between market making and proprietary trading. To avoid such a situation, the United Kingdom (“U.K.”) has its “Vickers” reforms, which will force banks to “ring-fence” their retail deposits in a separately capitalised subsidiary (read Glass Steagall Act). The Liikanen proposals in the U.K., have allowed banks to make markets and engage in proprietary trades, provided these activities are carried out in a ring-fenced entity.
Though India has been spared the worst of the crisis thanks to a robust prudential framework that is in place for banks, the Reserve Bank of India (“RBI”) has expressed concerns about banks managing private pools of capital. In this respect, the RBI has published on its website, a discussion paper titled “Regulation of Off-Balance Sheet Activities of Banks” (“Discussion Paper”). The Discussion Paper refers to the G-30 Report on ‘Financial Reform – A Framework for Financial Stability’1, which states that “large, systemically important banking institutions should be restricted from undertaking proprietary activities that present particularly high risks and serious conflicts of interest”.
The observations in the G-30 Report are pertinent, given the fact that the RBI in the past had banned select banks from undertaking proprietary trading in government bonds for a specific time-frame. In fact,as per media reports2, the Ministry of Finance and the RBI intends to put in place stringent regulations on financial entities taking risk with their own capital. It is also relevant to note that the RBI in the Discussion Paper has observed that “Indian banks have shown increased interest in sponsoring and managing private pools of capital such as venture capital funds and infrastructure funds. Therefore, there is need for banks to have greater awareness of the risks inherent in such activities and limit such exposures commensurate with their risk management and available capital. Keeping in view the reputational risk involved in such activities, the Reserve Bank had mandated maintenance of certain level of economic capital in some of the cases approved in the recent past.”
While Indian stock brokers engage in proprietary trading, ‘front running’ can be a matter of concern. ‘Front running’ entails a broker advising its client to sell a stock which such broker itself buys and vice versa. Front running can be achieved also through insider trading, wherein investment banks can use clients’ trading information to trade for themselves, before their clients. Such activities can boost broker’s profits at the expense of its clients. As per available statistics, losses to customers and gains to dealers from front-running in the United States restricted to treasury bonds alone run into hundreds of millions of dollars per year. In order to curb the menace of ‘front running’, SEBI (Securities Exchange Board of India) in the recent past has taken a tough stance against entities engaging in ‘front running’.
The RBI has adopted a stance, similar to the Volcker Rule, as far as banks’ engagement in riskier financial activities is concerned. This is evident from the Discussion Paper and the language in the draft guidelines on licensing of new banks in the private sector3 (“Draft Guidelines”). The Draft Guidelines state that “Banking is essentially based on fiduciary principles as depositors’ money is involved. It, therefore, becomes imperative that the fit and proper assessment framework for bank promoters is much more comprehensive in scope as compared to other sectors… There are certain activities, such as real estate and capital market activities, in particular broking activities which, apart from being inherently riskier, represent a business model and business culture which are quite misaligned with a banking model. Post-crisis, there are concerted moves even internationally to separate banking from proprietary trading. More importantly, in India, past experience with brokers on the boards of banks has not been satisfactory.”
The RBI in the Draft Guidelines has acknowledged that internationally too, there are attempts to “separate banking from proprietary trading” and in the interest of all involved, India needs to come up with its own version of how the ring-fence mechanism may be combined with the Volcker principle. It may be pertinent to note that other countries taking steps in the similar direction would definitely help make the process instrumental by lessening the chances of regulatory arbitrage.
While Indian stock brokers engage in proprietary trading, ‘front running’ can be a matter of concern. ‘Front running’ entails a broker advising its client to sell a stock which such broker itself buys and vice versa. Front running can be achieved also through insider trading, wherein investment banks can use clients’ trading information to trade for themselves, before their clients. Such activities can boost broker’s profits at the expense of its clients. As per available statistics, losses to customers and gains to dealers from front-running in the United States restricted to treasury bonds alone run into hundreds of millions of dollars per year. In order to curb the menace of ‘front running’, SEBI (Securities Exchange Board of India) in the recent past has taken a tough stance against entities engaging in ‘front running’.
The RBI has adopted a stance, similar to the Volcker Rule, as far as banks’ engagement in riskier financial activities is concerned. This is evident from the Discussion Paper and the language in the draft guidelines on licensing of new banks in the private sector3 (“Draft Guidelines”). The Draft Guidelines state that “Banking is essentially based on fiduciary principles as depositors’ money is involved. It, therefore, becomes imperative that the fit and proper assessment framework for bank promoters is much more comprehensive in scope as compared to other sectors… There are certain activities, such as real estate and capital market activities, in particular broking activities which, apart from being inherently riskier, represent a business model and business culture which are quite misaligned with a banking model. Post-crisis, there are concerted moves even internationally to separate banking from proprietary trading. More importantly, in India, past experience with brokers on the boards of banks has not been satisfactory.”
The RBI in the Draft Guidelines has acknowledged that internationally too, there are attempts to “separate banking from proprietary trading” and in the interest of all involved, India needs to come up with its own version of how the ring-fence mechanism may be combined with the Volcker principle. It may be pertinent to note that other countries taking steps in the similar direction would definitely help make the process instrumental by lessening the chances of regulatory arbitrage.
Footnote:- 1 Released on 15th January 2009. 2 Economic Times, “Government plans curbs on proprietary trading”, 22nd November 2011. 3 Released on 29th August 2011.
Disclaimer – Views of the author are personal and do not reflect the views of the firm.