Revoking legislation on banks as they gain access to billions in newly created government guaranteed loans, what could go wrong?

Welcome to Finance and Fury, the Furious Friday edition.

In the last two Furious Friday episodes, I’ve talked about the regulation and de-regulations on the monetary and fiscal sides.

1. Covered the Banking Act of 1933 and the Glass-Stegall section of this – then the financial de-regulations that occurred in 1986 and 1999 – some interesting events have played out since then
2. What I didn’t cover is that there was a step taken back after GFC – to help undo some of the de-regulation
   1. a rule in the US that was designed to prevent banks that receive federal and taxpayer backing in the form of deposit insurance and other support from engaging in risky trading activities – called the Volcker rule
3. but recently got watered down 3 weeks ago – might have something to do with loan products that banks are now offering due to business shut downs – interesting timing and connections which we will run through today

The Volcker Rule

1. is a federal regulation that aimed to prohibit banks from conducting certain investment activities with their own accounts – also aimed to limit their involvement with hedge funds and private equity funds – called covered funds
   1. The Volcker Rule aims to protect bank customers by preventing banks from making certain types of speculative investments that contributed to the 2008 financial crisis
2. Named after former Fed Chairman Paul Volcker, the Volcker Rule is a section of the Dodd-Frank Wall Street Reform and Consumer Protection Act
3. The Volcker Rule prohibits banks from using their own accounts for short-term proprietary trading –
   1. Proprietary trading occurs when a trader trades stocks, bonds, currencies, commodities, their derivatives, or other financial instruments with the firm’s own money, aka the nostro account, contrary to depositors’ money, in order to make a profit for itself – so using the banks own assets to trade was barred
   2. also bars banks, or insured depository institutions, from acquiring or retaining ownership interests in hedge funds or private equity funds beyond a cap of 3%
4. the rule aims to discourage banks from taking too much risk by barring them from using their own funds to make these types of investments to increase profits
   1. The Volcker Rule relies on the premise that these speculative trading activities do not benefit banks’ customers
   2. Still allows banks to continue normal activities – market-making, underwriting, hedging, trading government securities, engaging in insurance company activities, offering hedge funds and private equity funds, and acting as agents, brokers or custodians – all of this is allowed to generate profits
   3. But banks aren’t meant to engage in these activities if doing so would create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within the bank or within the overall U.S. financial system
   4. For instance = securitising their own lending and betting on this – or using their own funds to take too much risk on – as the banks own funds are meant to be protected with the TBTF legislation – take all the risk but bear none of the responsibility if it goes wrong
   5. Depending on their size, banks must meet varying levels of reporting requirements to disclose details of their covered trading activities to the government. Larger institutions must implement a program to ensure compliance with the new rules, and their programs are subject to independent testing and analysis. Smaller institutions are subject to lesser compliance and reporting requirements.
5. Think of it as a Glass-Stegall lite version – limits some activity but not all – there are always loopholes –
   1. Doesn’t say anything about using depositors’ funds – which are on ‘loan’ to the banks – so technically not their own money which wouldn’t be considered proprietary trading
   2. Also – where those who were proprietary traders or derivative traders left to set up their own shop – still had access to banks capital on loan – was still ongoing with the regulation’s implementation – kept having delays
   3. 2017 – the IMFs top risk official said that regulations to prevent speculative bets are hard to enforce due to the ways around the regulations

Background to this rule and what has occurred over the past few years up until the end of June this year

1. Origins date back to 2009 – Volcker proposed a piece of regulation in response to the ongoing financial crisis – due to the largest banks having accumulated large losses from their proprietary trading arms that could have sunk the rest of the bank if not bailed out
   1. Proposal aimed to prohibit banks from speculating in the markets using capital reserves and own assets
2. December 2013 – five federal agencies approved the final regulations that make up the Volcker Rule—the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Commodity Futures Trading Commission and the Securities and Exchange Commission (SEC)
3. went into effect on April 1, 2014 – banks needed full compliance by July 21, 2015
   1. Since then – the Fed has set procedures for banks to request extended time to transition into full compliance for certain activities and investments.
4. Skip forward to June 2017 – the Treasury – the Office of the Comptroller of the Currency – after conducting a review – said it recommends significant changes to the Volcker Rule
   1. said that it does not support its repeal and “supports the rule in principle” – i.e. the rule’s limitations on proprietary trading – but recommended exempting banks from the Volcker Rule banks with less than $10 billion in assets
   2. Treasury also cited regulatory compliance burdens created by the rule and suggested simplifying and refining the definitions of proprietary trading and covered funds on top of softening the regulation to allow banks to more easily hedge their risks.
   3. Federal Reserve’s Finance and Economics Discussion Series (FEDS) made a similar argument, saying that the Volcker Rule will reduce liquidity due to a reduction in banks’ market-making activities
5. Then – on May 30, 2018 – the Federal Reserve Board voted unanimously to push forward a proposal to loosen the restrictions around the Volcker Rule further – the goal according to Powell, is “…to replace overly complex and inefficient requirements with a more streamlined set of requirements”
6. In August of 2019, the Office of the Comptroller of the Currency voted to amend the Volcker Rule in an attempt to clarify what securities trading was and was not allowed by banks – wanted to redefine some terms
   1. The change would require the five regulatory agencies to sign off before going into effect, but is generally seen as a relaxation of the rule’s previous restriction on banks using their own funds to trade securities – allowing proprietary trading for some activities
   2. The proposal would eliminate a 3% cap on ownership of a venture capital fund. It would also allow banks to invest in debt-based funds among other changes.
7. So it has been watered down for years and wasn’t fully in force anyway – but now final nail in coffin as of June 25, 2020
8. the federal reserve relaxed part of the rules involving banks investing in venture capital and for derivative trading
9. Federal Deposit Insurance Commission (FDIC) – loosened restrictions in the Volcker rule on bank capital requirements and the levels of investments that banks can make in private equity and similar funds
   1. the banks will not have to set aside as much cash for derivatives trades between different units of the same firm- remember that this requirement had been put in place in the original rule to make sure that if speculative derivative bets went wrong, banks wouldn’t get wiped out.
   2. The loosening of those requirements could free up billions of dollars in capital for the industry to start betting again
10. So after the past few years – the Fed, FDIC, OCC and other agencies eased the aspect of Volcker that restricts lenders from engaging in proprietary trading — the practice of making market bets for themselves instead of on behalf of clients
    1. Under the existing rule, banks could make indirect investments into venture capital funds but faced restrictions on directly owning a fund – The rule change would also give banks more leeway to invest or sponsor credit funds that make loans, invest in debt securities, or extend credit.
    2. One implication of this rule change would be greater bank activity in the market for collateralized loan obligations (CLOs) – where banks were previously barred from involving themselves with CLO funds that included a debt component due to this being considered their own funds (or an asset)
    3. Federal Reserve Chairman Jerome Powell called the proposed change “a simpler, clearer approach to implementing the rule [which] makes it easier for both banks and regulators to carry out the intent of the rule”. Federal Reserve Governor Lael Brainard voted against the proposal, arguing that “several of the proposed changes will weaken core protections in the Volcker rule and enable banking firms again to engage in high-risk activities related to covered funds”

Why do this now? Only my speculation – no proof that this is occurring – but it lines up with billions being given out by banks that are government guaranteed as part of the US stimulus efforts.

1. Look at the GFC – with Synthetic CDOs – take thousands of loans – put them in a security – then take that security and others – and put it in other securities – then write contracts on them – betting about price movements – bets on bets analogy –
   1. Those loans back in GFC had government guarantees – from Fannnie Mae and Freddie Mac – gov lending
2. So if banks wanted to bet on bad loans – with Volker it was hard – but what is happening in the economy right now in the US?
3. The Paycheck Protection Program – part of the CARES act – designed to provide forgivable loans to businesses hurt by the coronavirus
4. The Act authorizes the Treasury, working in large part through the Federal Reserve, to make loans and loan guarantees available to eligible businesses.
   1. Title I – $350 billion for small business loans.
   2. Title IV – appropriates another $500 billion to aid mid-sized and large businesses
   3. $850bn in total – creating another winner in banks – as banks are the ones who are lending these funds
   4. Quick side note – Banks that made the government-guaranteed PPP loans to small businesses are set to collect billions of dollars in fees directly from the Small Business Administration
   5. Through the end of June, more than $521 billion in PPP loans had been approved, according to the latest data from the SBA
   6. Not out of the kindness of banks hearts – The top 10 lenders will receive an estimated total of more than $3.8 billion in fees
   7. S&P Global Market Intelligence- JPMorgan Chase, which is the largest PPP lender after extending nearly $29 billion worth of the loans, is on track to make some $864 million in fees. Bank of America, the next biggest, will rake in an estimated $755 million in fees on its PPP loans
      1. Under Treasury Department rules, PPP lenders can charge processing fees between 1% and 5%, depending on the amount of the loan – 5% on loans of $350,000 or less – 1% on loans of $2 million and above
   8. Lenders are barred from collecting the fees from the small businesses applying for PPP loans; instead, the SBA will cover the costs
   9. But banks can’t count the fees as revenue immediately—they have to wait until the loans are either forgiven or paid back by the company, which could take years – unless the company goes out of business
5. While the revenue from PPP fees is a small portion of the overall revenue of big banks, the program does create new assets for them to securitise – again I don’t know that this is going on – but if profits can be made – and the legislation is now removed that limited banks doing this – why wouldn’t they? why not profit off these loans – through getting back into securitising and betting on these?
6. PPP loans – banks are providing these – but know that a chunk of these are likely bad loans – and can be gambled on if securitized
   1. Estimates that 20% of small businesses in the US will cease to operate due to their lockdowns
   2. Know that the funds are guaranteed – Could be a large amount of companies that fail – but banks bets are covered
   3. What can go wrong? Involves similar hubris to the 2008 crash – as banks thought that mortgages are safe – nobody ever defaults on a mortgage and if they do, then it is only 1-2% – so the rest are safe
7. So all of this could be nothing – but I wouldn’t be surprised if this creates another form of bubble over the next few years as these loans mature

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