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Scores of lawyers will begin poring over the voluminous Volcker Rule on Tuesday morning. (Brendan McDermid/REUTERS)
Scores of lawyers will begin poring over the voluminous Volcker Rule on Tuesday morning. (Brendan McDermid/REUTERS)

The Volcker Rule: Banks have reason to be apprehensive Add to ...

Wall Street is preparing to swallow a bitter pill as the U.S. government finalizes a last dose of medicine for the banking industry to ward off a future financial crisis.

After nearly four years of negotiations, U.S. regulators are expected on Tuesday to approve a definitive version of a contentious rule to curb risk-taking by banks.

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Known as the Volcker Rule, the measure forbids banks from engaging in trading solely for their own profit.

Defining the limits of proprietary trading has proven a slippery endeavour.

Ever since the United States passed a financial-reform law in 2010, regulators and the banking industry have sparred about what should and should not be allowed. The final version of the rule marks the conclusion of that battle – and will indicate which side gained the upper hand.

Tuesday is “as big a day as there will be” in the journey to reform the banking industry after the financial crisis, said H. Rodgin Cohen, a partner at Sullivan & Cromwell LLP in New York who is considered the dean of Wall Street lawyers. “This is a rule geared obviously at the big trading banks and has enormous ramifications.”

Mr. Cohen said that among his clients, “There’s trepidation as to substance, but there is also concern about error” given the complexity and length of the rule (together with a preamble, it is reportedly close to 1,000 pages).

Banks have reason to be apprehensive. “The Volcker regulations will potentially impact the profitability and market shares of the large capital markets banks [and] the future of the U.S. corporate bond market,” wrote Brad Hintz, a banking analyst at Sanford C. Bernstein & Co., in a note to clients on Friday.

The rule’s proponents – chief among them Paul Volcker, former chairman of the U.S. Federal Reserve – argue that it is a necessary step to prevent banks from engaging in risky activities for their own benefit while enjoying support from the government, for example through federally insured deposits.

If regulators stick with the strictest interpretation of the new rules, it could cost the eight largest U.S. banks up to $10-billion (U.S.) in annual profits, according to a report last year from ratings agency Standard & Poor’s. Under a more lenient version, the banks would see their profits reduced by up to $3-billion, it estimated.

Some of those costs have already been absorbed. Banks have jettisoned their proprietary trading desks, which were staffed by traders whose sole job was to bet the bank’s own money in search of short-term profits. Banks have also spun off hedge funds and private equity vehicles that they used to sponsor.

Now comes the sticky part: Banks are about to find out how regulators will distinguish between trades that facilitate transactions by clients and those whose main purpose is to boost the bank’s bottom line. (Mr. Volcker once famously said that the difference would not be hard to spot. “Every banker I speak with knows very well what proprietary trading means and implies,” he testified before a U.S. Senate banking committee in 2010. He later added, “It’s like pornography. You know it when you see it.”)

At least one widespread practice will fall afoul of the rules, according to a recent report in The Wall Street Journal: portfolio hedging, or trades that are intended to offset losses over a wide range of positions. Such hedging is exactly how JPMorgan Chase & Co. described the activities that led to the “London whale” trading fiasco, which ended up costing the bank more than $6-billion.

Chief executives at banks will also reportedly be required to certify their institutions’ compliance with the Volcker Rule, a step aimed at increasing accountability that the industry had opposed.

On Tuesday morning, teams of lawyers will begin the work of poring over the rule and analyzing its contents. At Sullivan & Cromwell, Mr. Cohen said at least 20 lawyers will be involved and he expected the firm would not have its preliminary views ready until that evening or the following morning.

Lawyers will also be watching the votes at the different regulatory bodies that will take up the Volcker Rule on Tuesday. While it is expected to be approved in all cases, any dissenting votes could provide a road map for potential lawsuits.

Such disagreements will show “whether there are regulators who think there were process problems” in drafting the final version of the rule, said Andrew Olmem, a partner at Venable LLP who formerly worked as a lawyer for the Senate banking committee. “Process problems can lead to court challenges.”

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