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Curatia Analysis for Thu, Aug 22

Billed as a Modest Win, Volcker 2.0 Instead Reveals Structural Headwinds for Banks

Long-anticipated revisions to the Volcker Rule unveiled Tuesday proved more incremental than transformative, aiding banks modestly in increasing trading volumes and liquidity, diversifying their operations, and reducing their compliance burdens.

But even a tea party with bite-sized cupcakes feels extravagant given the nature and extent of banks’ trading difficulties and the implication that further regulatory reform figures to be an uphill struggle.

The Basics

In a move aimed at liberating boutique banks from the Tyranny of Compliance, regulators will now presume firms with less than $1B in trading assets and liabilities are complying with bank trading restrictions.

Bulge-bracket banks, meanwhile, will no longer need to prove to regulators that “trades held for less than 60 days weren’t made for the firms’ own short-term profit or otherwise prohibited.” Those changes will aid bank efforts to make markets and hedge against losses.

Volcker Rule revisions also ease restrictions on banks investing in hedge funds or private equity funds on behalf of clients or to underwrite securities.

The FDIC and OCC approved the changes Tuesday. They will take effect from the start of 2020 pending expected approvals from the Fed, the SEC, and the CFTC. Volcker 2.0 “also seems likely to face a legal battle,” according to one Bloomberg opinion piece.

Impacts

Potentially the revisions’ “most significant business impact for the industry” comes in the form of loosened restrictions on investments in hedge funds and private equity funds. The changes could help banks diversify their revenue streams by ramping up investments in those areas at a time when the private equity space looks healthier than trading.

Curbed compliance requirements could also help boutique banks control costs. Bank officials have said that benefit is unlikely to apply to their firms given a wide range of other compliance demands, however.

On the trading front, Volcker 2.0 will likely “increase market volume and liquidity only modestly” and “doesn’t feel much different,” an industry analyst said. Sensing the unlikelihood of a major victory, “several bank officials involved in the discussions said in recent months that they wished the regulators would just drop the revision effort all together,” per Bloomberg.

But those predictions have done little to quiet opponents of financial regulatory reform. Some including Obama-appointed FDIC board member Martin Gruenberg, who voted against the changes, have cautioned they could confer substantial benefits to banks. He calculated Volcker 2.0 would reduce the scope of financial instruments covered by the Volcker Rule by 25%.

Others have warned of the slippery slope of financial deregulation. “‘No individual thing jumps out, but if you look at the sum total, the direction of travel is not entirely encouraging,’” former Fed governor Jeremy Stein said.

The unlikelihood of a major victory and the potential for a backlash against Volcker reforms may have dampened the spirits of bank officials involved in the discussions, who “said in recent months that they wished the regulators would just drop the revision effort all together.”

Outlook

In fact, Volcker 2.0 arguably testifies to how boxed in banks are in the broader battle to revitalize their trading operations. With prop trading still banned, Volcker revisions streamline the rule at the margins rather than overhauling it.

And even a wholesale repeal of the Volcker Rule tomorrow would do nothing to unwind its fundamental role in displacing banks from the market-making equation over the last decade.

Trading revenue at US bulge-bracket banks has dropped in four of the last five years — a trend that’s gathered pace in 2019. Trading revenue dropped 14% in Q1 and 8% in Q2 en route to its worst H1 since the financial crisis.

As discussed last week, many banks are not only diversifying into other business lines but also scaling back their trading operations and have already restructured to reflect that priority. Moreover, competition from trading firms is now formidable.

Other forces that have figured significantly in the decline of bank trading — electronification, for example — remain in force.

Furthermore, it's unclear whether banks would even desire a full-scale repeal of the Volcker Rule or a broader gutting of Dodd-Frank, given the risks those moves could engender or the spotlight it could shine on finance sector regulation as a campaign issue in 2020 US elections.

Whether the Volcker Rule revamp proves a gateway to further regulatory easing likely depends first and foremost on the outcome of those elections. But the evidence from Volcker 2.0 and last year's Dodd-Frank revisions indicates a limited appetite for cautious deregulation among US agencies.