Structural reforms have consumed an immense amount of time and effort from regulators and industry participants in the past few years, but will they be made obsolete by more general changes to the global banking market? 

For many years, the US Volcker Rule was the poster-child of structural reform in the banking sector. Though it was never originally intended for inclusion in the 2010 Dodd-Frank Act, an endorsement from president Barack Obama and other senior figures saw it added as a late-stage amendment, creating furious debate over whether it was appropriate, or even feasible. 

In theory, prohibiting banks from engaging in ‘proprietary trading’ – that is, trades designed solely to turn a profit for the bank, rather than hedge risk or offer liquidity to clients – with depositors’ money sounds simple. As it turned out, the stricture dropped regulators and banks into a rule-making minefield. 

Merely defining what did and did not constitute proprietary trading proved incredibly complicated. For instance, can regulators ever tell for sure if a position is a legitimate hedge, or a speculative trade? What if a bank pre-hedges a client position it expects to take on in the near future? Is that trade in contravention of the rule for the short time in which it sits on the books without a matching position?

Meeting Volcker standards 

The amount of time and effort spent resolving this question and others like it was indicated by the sheer heft of the final Volcker Rule text, which ran to more than 900 pages when it was finally introduced in 2014. 

Banks have employed a range of tools to comply with the measure. Chief among these has been internal infrastructural controls on trading that can help prove that trades are legitimate should regulators ever come knocking. “We have designed software to check whether a trade is permissible or non-permissible, and to prevent rogue traders using synthetic trades to bypass risk and compliance controls,” says Kelvin To, founder and president of Data Boiler Technologies. “However, banks still have a long way to go and a lot of work to do to be fully at peace with the Volcker Rule standards.”

Worse still, just two years after the rule was introduced, many in the industry feel that it has not produced anything worth the massive amount of time and effort spent constructing it. “In my view, it’s a dead weight loss. It’s not something that was needed, it creates cost and doesn’t materially improve the safety and soundness of the banking system,” says one former senior banker. “Other than that, it’s been a great success.” 

Others point to problems with Volcker’s risk-blind approach to which proprietary positions are acceptable, and which are not. “It is evidently alright to make a long-term illiquid investment in a loan, but if that exact same cash flow is packaged as a security, then you have a problem if you want to stay in compliance with Volcker,” says Thomas Huertas, chair of the EY global regulatory network and former deputy chair at the European Banking Authority. In other words, taking proprietary positions on potentially illiquid loans using depositor cash is permitted, but taking proprietary positions in provably liquid securities with depositor cash is not.

To use, no point? 

In the end, Volcker may be overtaken by other developments in the derivatives landscape. Volcker was designed to control banks’ derivatives use, but that use seems to be declining day by day. Significant increases in required capital ratios and the introduction of new liquidity ratios brought in by Basel III have made market-making a much more expensive exercise. The steady introduction of mandatory central clearing for standardised, over-the-counter derivatives has added an extra logistical headache to participation in the market. Constraints on risk weighted assets (RWAs) have already prompted some smaller scale structural changes at big dealer banks. 

“Banks have reacted to higher capital requirements by slashing RWAs. Part of that is making sure the RWAs you do have are doing the most for you – making sure you’ve got your exposures and collateral domiciled in the same place, for instance. Your book is fundamentally mismatched if your bond portfolio is in Hong Kong but the derivatives portfolio that hedges it is in London. A lot of work has been done around building a consistent booking model, making sure collateral is in the right place, making sure all the documentation supporting each trade is correct,” says Keith Pogson, global banking and capital markets assurance leader at EY in Hong Kong. “RWAs come at a high premium in modern banking, so everyone is looking to eke out a bit more.” 

In many cases, this paring back of RWAs has not been enough to produce a workable business model that includes large derivatives trading books. Consequently, some banks have either made cutbacks in some product lines, or left markets entirely. The Royal Bank of Scotland, for instance, has shut down its equities and equity derivatives business. Deutsche Bank is pulling back from credit derivatives, UBS has already exited from fixed-income trading in general, and other banks are pursuing radically slimmed down derivatives operations. US banks are typically in a stronger position in terms of capital and profitability, but a readjustment toward the derivatives market is under way there, too. 

Highlighting the specific impact of individual regulatory changes to overall market or bank behaviour is hard, but there is a growing sense that the Volcker Rule is becoming obsolete. “It was a good transitioning discussion, but if we took the rule away, would all the US banks rush headlong back into proprietary trading? Maybe one or two would, but most simply couldn’t due to cost increases. Derivatives books are run from a very different viewpoint these days,” says Mr Pogson.

From Volcker to Vickers 

Structural reform in Europe, particularly the recommendations made by the UK’s Independent Commission on Banking, known colloquially as the Vickers recommendations after the commission’s chairman, Sir John Vickers, promises to be much further reaching than Volcker. Vickers will mandate the ring-fencing of the investment banking activities of UK banks from their retail activities. 

“In some ways Vickers goes a step beyond similar structural reforms, such as the US Glass-Steagall Act, as it will force UK banks to carve up their businesses in a manner that is really quite radical. It puts limits on the ability to invest in securities, to engage in derivatives and foreign exchange trades, and to establish foreign branches, all of which are legitimate banking activities. None of these were prohibited for US commercial banks under Glass-Steagall,” says Mr Huertas at EY.

As with Volcker, the impact of any specific structural reform programme in other jurisdictions may be eclipsed by more generic changes. As Mr Pogson notes above, banks are becoming more regionalised of their own accord, aligning capital, liquidity and collateral to local exposures and local trading books. 

“The universal banking model is suffocating. The global banking model may soon follow. Perhaps the best that can be hoped for from the very largest banks is that they operate a global network of virtually stand-alone subsidiaries, all covered by a warm, fuzzy wrapper of branding and service consistency,” adds Mr Pogson.

Structural consistency 

Rather than setting up a hodge-podge of branches, subsidiaries and holding entities across a swathe of countries, banks are more and more aiming for structural consistency across the board. This makes sense from an operational perspective – having similar governance structures across multiple locations means that personnel can be plugged into different locations without the time-consuming and expensive training process that would be required under a clunkier, customised operating model. 

It is also a popular solution among regulators. The US Federal Reserve requires foreign banks operating within its jurisdiction to establish themselves as ‘intermediate holding entities’, effectively a subsidiary system that requires banks to hold locally a significant amount of capital and liquidity against their US activities. The Bank of England can also require foreign banks to establish themselves as subsidiaries if they deem their activities to be systemically significant. 

As this trend picks up speed, the idea of imposing specific structural reforms could soon look a little dated. Especially as continuing work on recovery and resolution makes dealing with a bank collapse a little easier, and the Financial Stability Board’s total loss-absorbing capacity (TLAC) proposals make a bank collapse a little less likely. 

“The intent of structural reform to was to increase the safety and soundness of banks and make them more resolvable. There is another way to do this more efficiently – the introduction of TLAC and improvements in resolution procedures. Had the innovations been in place quickly after the crisis, I personally doubt there would have been as much support for structural reform,” says Mr Huertas.


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