Volcker rule creates asset management concern

Global asset managers and governments are raising the alarm over the Volcker rule – a controversial US regulatory reform which they say could negatively impact markets.

The complex 298-page proposal prevents US banks from engaging in proprietary trading – using client and public money to open accounts and take principal positions in underlying assets.

But in an atmosphere of growing disquiet among market participants and politicians, the Federal Reserve recently extended the consultation period on Volcker to February 13, 2012, to gauge wider opinion.

The Volcker rule, named after former chairman of the Federal Reserve Paul Volcker, is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It is predicated on removing the implicit backstop of a state bailout when banks make high-risk investments. The rule is due to come into force no later than 21 July, 2012.

As currently worded, Volcker would apply to any bank with a single branch, agency, commercial lending subsidiary in the US, or with any US residents as investors in its funds. Banks governed by the rule would only be permitted to run US mutual funds regulated under the 1940 Investment Company Act.

One interpretation declares that any large retail bank with US interests would fall foul of Volcker if they ran European UCITS funds, Canadian mutual funds or Japanese investment trusts.

Federal Reserve Governor Daniel K. Tarullo has said: “The proprietary trading prohibition in the Volcker Rule statute itself will undoubtedly affect the trading behavior of banking entities. Indeed, that is what Congress intended. It also would limit their investments in private-equity and hedge funds.”¹ As UCITS and Canadian mutual fund rules have integrated complex strategies and derivatives, their ability to launch or operate those products will be limited.

The Volcker rule gives the affected banks two years to comply after it comes into force.

ICI Global, a recently launched global trade body for the fund management industry, says that banks would be barred from managing any investment products other than exempted US mutual funds, distributing them using the bank’s brand, or seeding them with the bank’s capital. It adds that non-bank-owned fund houses will also be affected as they will not be allowed to have distribution agreements in place with the affected banks.

As the financial world is globally integrated, it becomes clear that domestic US legislation will have impact on all major markets.

In a wide-ranging interview with the UK newspaper The Sunday Telegraph in January, Gary Cohn, the President of Goldman Sachs, said that the Volcker rule could have a calamitous effect. “If the Volcker rule goes through as written and interpreted today liquidity in all markets will dry up,” he said. ²

This is not an isolated opinion. A report by consultancy Oliver Wyman, published earlier this year, said corporate bonds could suffer a USD 315bn paper loss because of a sharp decrease in market liquidity. It claims issuers would see annual borrowing costs rise by USD 43bn and investors would experience a USD 4bn increase in transaction costs.

In addition, there are concerns the rule will unsettle the operation of sovereign debt markets. The Office of the Superintendent of Financial Institutions Canada wrote to the Federal Reserve in December 2011 saying it “strongly believed” that foreign government securities should be given exemptions for banking groups who parents were located outside of the US.

Japanese Financial Services Authority and the Bank Of Japan sent a joint letter to the Federal Reserve saying that Volcker would also squeeze US dollar funding because of restrictions on short-term FX swap arrangements and could delay decision-making around investment in non-US funds.³

The final wording of the Volcker Rule still has to be determined and it is likely that lobbyists and politicians will engage in more horse-trading before reaching a conclusive agreement. However, it seems certain that the sentiment driving the rule will remain largely intact, meaning that whatever the outcome of the Volcker Rule, asset managers will once again have to find a way to adapt to the impact of another seismic regulatory shift.

David Dibben
Head Global Fund Products

1. Before the Subcommittee on Capital Markets and Government Sponsored Enterprises and the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, U.S. House of Representatives, Washington, D.C. January 18, 2012

2. The Daily Telegraph, January 14, 2012. “UK Faces Volcker Rule Clash”

3. Financial Express, January 16, 2012. “Canada and Japan Sound Warnings on Volcker Rule”

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