The Volcker Rule: Observations on Systemic Resiliency, Competition, and Implementation
Commissioner Kara M. Stein
Feb. 9, 2015
Thank you, Mr. Fumiaki Miyahara, for your kind introduction.
Before I begin my remarks, I am required to tell you that the views I am expressing today are my own and do not necessarily reflect those of the United States Securities and Exchange Commission (SEC), my fellow Commissioners, or the staff of the Commission.
It is wonderful to be here this morning. The U.S.-Japan relationship is a deep and strong one, and I’m especially pleased to be making my first international trip as a SEC Commissioner to Japan. After spending a couple of days in Tokyo, I’ll travel to Seoul, Korea, to serve as the SEC’s representative at the Board meeting of the International Organization of Securities Commissions (IOSCO).
With regulators from more than 115 jurisdictions, representing more than 95 percent of the world’s securities markets, IOSCO serves as a hub of information sharing, research, and coordination on securities regulation and enforcement. It also works closely with other international colleges of financial regulators, such as the Financial Stability Board, to advance global financial regulatory coordination.
As you all know, our economies and markets increasingly are connected to one another. Financial relationships are no longer constrained by geographic boundaries. Nor are the economics of a financial transaction limited to the place where the transaction is executed. Just as today’s markets allocate capital around the world, the embedded risks, too, may be transmitted beyond the counterparties directly involved in a financial transaction. The resulting complexities and interconnectedness of our markets mean that IOSCO’s mission and role are more important than ever.
Today, I would like to focus my remarks on change — specifically, certain changes in the U.S financial system brought on by the Volcker Rule. In the United States, the separation of commercial from investment banking for many years helped shape a system where capital markets play a large role in intermediating credit between lenders and borrowers. Notably, for many years Japan and the U.S. shared this model of separating commercial from investment banking. In contrast, Europe and some other parts of Asia maintained universal banking. As a result, bank lending today plays a much bigger role in credit extension in those countries.
In the U.S., this legal separation between commercial and investment banking ended in 1999, with the effective repeal of the Glass-Stegall Act, allowing the two systems to blend together and overlap. Consequently, in 2007 and 2008, when stress developed in one part of the U.S. financial system, it quickly cascaded throughout the rest of system, destabilizing markets and institutions seemingly far removed from the locus of the crisis.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) put the traditional separation partially back in place, drawing a new line between customer-focused banking and proprietary trading. This “Prohibition and Restrictions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds” was originally proposed by former Federal Reserve Chairman Paul Volcker, and is now called the Volcker Rule.
Given our shared history when it comes to the separation of commercial and investment banking, I thought that being here in Japan would offer a good opportunity for me to share a few thoughts on the Volcker Rule.
Some of you know that I was very focused on the Volcker Rule during my first few months at the Securities and Exchange Commission, when we were negotiating the final regulatory details. But I also watched it develop and be negotiated when I worked in the United States Senate. With that perspective, I thought I would discuss the rule’s design and how I see it going forward.
First, I’ll touch on why I believe the Volcker Rule firewall is a valuable tool for enhancing systemic resilience. Second, I’ll discuss how I view some of the current debates surrounding the Volcker Rule. And third, I’ll touch on what I believe regulators can do to help ensure strong, speedy, and fair implementation. I will also note a few areas that may be of particular importance to Japanese financial firms.
Why the Volcker Rule Matters for Systemic Resiliency
Let me very briefly recap the history of the Volcker Rule. It began as a simple concept. Much like in Japan, United States consumers rely on a government guarantee, commonly known as federal deposit insurance, to give them confidence that monies they deposit with commercial banks will not be lost. Commercial banks then lend those deposited funds to families and businesses, which is key to economic growth. However, Congress believed that speculative trading should not be subsidized or guaranteed by the government.
Endorsed by President Obama, the Volcker Rule was enacted into the Dodd-Frank Act. It imposes prohibitions and restrictions on a banking entity that seeks to engage in proprietary trading and seeks to have certain interests in, or relationships with, a hedge fund or private equity fund. The Volcker Rule applies to United States’ banks and their affiliates anywhere in the world, as well as foreign banks that operate in the U.S.
Regulators, including the Commission, codified the Volcker Rule in December of 2013. Currently, we are in a good faith conformance period, where banks are working to bring themselves into compliance. That period will end on July 21, 2015, although the Federal Reserve recently granted an extension that gives banking entities potentially two additional years to conform legacy hedge fund and private equity fund activities.
Decreasing Excessive Risk-Taking
The logic of the rule comes out of the 2008 financial crisis. Record asset inventories and leverage emerged in the trading operations of the largest banks and dealers, including on balance sheet through the trading account, and off-balance sheet through funds and special purpose vehicles. This led to a crisis that threatened the entire U.S. financial system and necessitated a massive rescue, both in ways that did not respect previously understood boundaries or safeguards.
The Volcker Rule seeks to limit those threats and the need for that type of a rescue by restoring part of the firewall between commercial and investment banking, redrawn in ways to reflect some of the more potent risks modern markets pose. As such, the firewall covers activities that had previously not been captured by Glass-Steagall—like swaps, securitization vehicles, and offshore activities. Yet, it also permits certain activities, like underwriting and market-making, that Glass-Steagall had prohibited. Overall, it seeks to limit excessive risk-taking in each of the covered areas by ensuring that the bank is focused on serving its customers, and not on making large, speculative bets.
Such excessive risk-taking, during the boom and crash, had also fueled incredible conflicts of interest. As we now know, firms were betting against the same complex financial products that they were packaging and selling to their clients. The Volcker Rule, which has its own provisions on conflicts of interest, together with provisions addressing conflicts of interest in the securitization process (section 621 of the Dodd-Frank Act), are important protections against the return of some of these practices.
I think it is fair to say that the Volcker Rule was designed to change the very approach of the largest dealer-banks by limiting certain activities and incentives. Banking traditionally has been an honorable profession and bank professionals should be able to take pride in helping to provide capital to growing businesses or successfully managing investors’ money. Frankly, I believe there is a genuine desire among most bankers to regain the public’s trust and respect. But to do that, bank CEOs and Boards of Directors need to continue to rethink and re-envision their mission, as well as the incentives of their firms that encourage excessive risk-taking. That is part of why I pushed so hard for (1) CEO and board level involvement in implementation of the rule’s requirements; (2) application of the rule at the trading desk level; and (3) strong limits on trader compensation incentives. Ultimately, one of the lessons of the financial crisis is that many bank executives and many financial regulators did not fully understand the nature and extent of, or the incentives for, the excessive risk-taking that was occurring across the U.S. financial system.
It is also clear to me that the Volcker Rule has a critical role to play in promoting financial system resilience—or the ability of the financial system to withstand stress. Specifically, by limiting the ability of banks to take large and risky bets on behalf of their own bank, the Volcker Rule acts to limit the correlation between our largest dealer-banks and the markets they serve. This, in turn, provides a buffer when markets behave in ways even the best models do not predict. This is especially important in U.S. markets, where dealer-banks play a large role in credit intermediation.
We in the United States should have learned this lesson in 1998. Back then, a disorderly unwinding of the hedge fund Long-Term Capital Management’s positions posed such a grave danger to the major dealer-banks that the Federal Reserve Bank of New York organized a privately-funded bailout. The collapse of that particular hedge fund was such a problem for the dealer-banks because those banks had accumulated enormous exposures to the same levered bets that the hedge fund had made. Not only were those investment banks lending to Long-Term Capital Management, they were also directly invested in the hedge fund. And many of them, through their own trading operations, had also made the same big bets as Long-Term Capital Management. In short, Long-Term Capital Management, the big dealer-banks, and the entire market had become so closely correlated, that if anything went awry, it would potentially take down the entire system.
Sadly, instead of learning from that warning signal in 1998, market participants continued to accumulate leverage and risk. When things did go haywire in 2007 and 2008, we all saw the result.
Let us be clear. The Volcker Rule is not designed to prevent U.S. firms or the U.S. financial system from taking every form of risk. Nor should it be. It is designed to decrease excessive risk-taking and reasonably increase systemic resilience. By reducing the spill-overs when big shifts in the trading market hit one firm after another, the rule should allow markets to shift and move, ideally, without knocking out the key infrastructures the market needs to function. This should also help allow financial firms to fail without taking out innocent bystanders. Of course, the Volcker Rule needs to work together with capital, swaps, repo, and other reforms that aim to reduce leverage and interconnectedness.
Some Observations on Current Debates: Bond Market Liquidity and Competitiveness
So how do things look today? I’d like to spend a few minutes talking about the relationship between the Volcker Rule and bond market liquidity, and between the Volcker Rule and international competitiveness.
Bond Market Liquidity
At least in the U.S., there has been a fair amount of attention recently on the topic of liquidity in the bond market, especially the corporate bond market. Some have even asserted that the Volcker Rule is to blame. I am not convinced it is at this point in time, or at least in the adverse way its critics are suggesting.
To begin with, 2014 was a banner year for corporate debt issuance. More than $1 trillion in corporate debt was raised in the United States and $3.8 trillion was raised outside the United States, including $58 billion in Japan.
First, let us look at dealer inventories. It does appear that dealer inventory of corporate bonds is down. But inventories are down in relation to the height of the crisis. Inventory levels today are actually comparable to a few years prior to the crisis. This, it would seem, is appropriate. Moreover, we need to ask ourselves whether dealer inventory is the best proxy for liquidity. To put it another way, do we really want to bring back massively leveraged inventories at dealer-banks? I suspect not.
Moreover, real liquidity has to last “through the macroeconomic cycle,” and not depend solely on the booms or busts of the market for depth and strength. Looking back, it certainly seemed like the sense of liquidity that existed in the run up to the financial crisis was built on shallow and shaky foundations.
Furthermore, while it is essential, liquidity might not be an unadulterated good. As former Federal Reserve Chairman Volcker stated on liquidity before the financial crisis: “traders’ and investors’ sense of an ability to sell anything instantaneously contributed to the excessive leveraging and risk-taking that led up to the crisis.” Clearly, as we look at corporate bond markets, we should be focused on authentic or real liquidity. Arguably, this is liquidity that allows investors to exit investments in an orderly way and allows market-makers to help them do so. But liquidity is not real if it gives investors a sense of false comfort while making investment decisions.
In addition, I think it is worth maintaining a degree of humility in the face of complex, multifaceted, and interconnected financial markets. We must remember that other factors, such as monetary policy or changes in bond market structures and players, may have a far stronger impact on when and how corporate bonds are traded. Indeed, I am open to taking new and creative steps to improve our fixed income market structures, including pre-trade and post-trade transparency.
I also would note that the Volcker Rule itself, as implemented through our quantitative metrics regime, contains a degree of flexibility. To that end, I hope that we can begin providing additional transparency regarding those metrics to the market. In addition, U.S regulators need to work collaboratively and share the collected data. This will help people understand how the Volcker Rule is working and hold regulators to account for implementing it appropriately.
There is another strain of thought that asserts that the Volcker Rule could put the U.S. financial system at a competitive disadvantage globally. It could do this by pushing the trading of financial products to less regulated firms or markets, including outside the United States.
I appreciate the concerns of these commentators, but I believe the Volcker Rule is largely a benefit to the real economy. We know that a stable financial system is a prerequisite to healthy growth in the non-financial, commercial sectors of an economy. The Volcker Rule is about not imperiling those “real economy” sectors by running up risk in the financial system. Equally importantly, though, competition is better served by preventing an over-concentration of activities within large “universal” banks. Indeed, I believe one of the strengths of the U.S. financial system, and one of the reasons that our capital markets are so vibrant, is that historically we have had so many diverse players in the financial marketplace. Those players can compete better when there is a level playing field and they are not going up against the largest dealer-banks that gain access to extraordinary financial and informational resources — resources that those outside the bank “safety net” simply cannot obtain.
Nevertheless, as Chairman Volcker and others have asserted, the Volcker Rule leaves plenty of space for U.S. dealer-banks to play a large and multifaceted role in the global financial system. Strong regulation has long been a source of competitive strength for the U.S. financial system.
I think that we also should avoid making the pre-2008 mistake of looking at financial centers from a “market share” perspective. First, this outlook incentivizes regulatory arbitrage and a race to the bottom. Second, it fails to capture important changes to our global economy in recent years. As economies grow in emerging markets, they will naturally seek to establish their own financial marketplaces and regulatory structures, much like Japan has done. This is both natural and to be expected. Just as diversity in investments or diversity in an economy are healthy, so too is diversifying financial system risk across nations and marketplaces.
Implementation: Next Steps towards a Strong, Speedy, and Fair Volcker Rule
I believe we are at a critical juncture in the financial reform process. Like many of the most important U.S. reforms, the Volcker Rule is still in the process of being implemented. While the premise behind the Volcker Rule is relatively simple, there is no doubt that implementing it at today’s large complex financial institutions, with their thousands of subsidiaries spanning the globe, is complex. Moreover, despite their best efforts, our rule writers could not have conceived of every possible question about or interpretation of the rule.
As a result, in order to enable firms to effectively implement the rule, regulators need to provide meaningful guidance and answer questions in a timely and transparent manner. For example, here in Japan, some firms may be seeking to understand what affect the Volcker Rule has on how Japanese banks can interact with hedge funds and private equity funds that have U.S. connections. Or you may be interested in how the Volcker Rule treats the foreign equivalent of mutual funds. Other questions that might merit guidance include whether firms that “seed” a fund with a small amount— say $5 million or so — can do so over the usual three-year period needed to create a track record, without asking the regulators for extensions each year of the three-year period.
Regulators cannot answer every question. Nor should implementation of the rules be delayed any further, and certainly not until after every possible question is answered. That said, regulators have an obligation to be responsive and transparent about the implementation process.
So far, I believe that the staff at the United States’ regulatory agencies implementing the Volcker Rule (the Volcker Rule Working Group) have done a good job on a tough assignment. As we move from the initial implementation into supervision and compliance, keeping that strong cooperation between the agencies is critical. But I hope that our processes can continue to evolve and improve.
I would suggest, for example, that the Volcker Rule Working Group consider establishing a deadline, such as 60 days, for indicating whether a question regarding the Volcker Rule will be answered or not, and then have a deadline for answering it. The agencies and public would also be well-served if there were additional ways for the public to be aware of the types of questions that are being asked before they are answered. Providing clarity and transparency around the guidance process will not only help industry comply, but also speed effective implementation of this important financial reform.
In conclusion, I would like to step back and look again at the broader landscape. One of the key lessons I hope we all learned from the financial crisis is that risk does not respect borders. Japan and its banks were relatively unscathed, but others were not so fortunate. The United States recognized that rescuing certain financial institutions was needed not only to support the U.S. economic infrastructure, but also to add stability to the global economy. It should not be forgotten that many aspects of the 2008 rescue, including the bailout of AIG, the Federal Reserve’s emergency credit lines, and the Treasury Department’s rescue of money-market mutual funds, had significant cross-border implications.
As a result, United States policymakers recognized the need to ensure that financial reforms addressed important cross-border vulnerabilities. That is why our swaps rules were drafted to give regulators broad authority to capture foreign activities that could impact the United States or function as an evasion of our regime. That is why the Federal Reserve implemented the Foreign Banking Organization rule that strengthens its oversight of the U.S. operations of foreign broker-dealers. And it is one of the reasons why the Volcker Rule was written with such broad global coverage.
Japan has an interest in addressing cross-border vulnerabilities too. Although Japanese banks did not need a bailout in the 2008 crisis, Japan’s economy was clearly impacted by the global recession.
Ultimately, I believe the Volcker Rule is a vitally important reform that will make a real difference in improving financial system resilience and competitiveness in the United States, with a positive impact on the global system. But I also want to hear from you. No matter who or where you are — a bank executive in Tokyo’s Nihonbashi District, a trader on Wall Street, a researcher in academia, or a person with a retirement fund — share your insights with me and the Commission.
Going forward, we in the United States, Japan, and elsewhere need to be talking and coordinating internationally on a wide range of important financial reforms, which is again why I am so pleased to be attending the IOSCO Board Meeting in Seoul. But I also hope and trust that international market participants and regulators, in Japan and elsewhere, will view diversity as a source of strength. Respecting each other and working together, we can nurture diverse, competitive, and resilient financial markets that support solid economic growth for hard-working families around the world.
 Some scholars assert that the Glass-Steagall Act’s separation of commercial from investment banking in the U.S. may have made the U.S. financial markets more efficient and U.S. institutions more competitive, leading to a higher growth rate for the U.S. economy. See Matthew Richardson et al., Large Banks and the Volcker Rule, in Viral V. Acharya et al., Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, John Wiley & Sons, Inc., p.188 (2010).
 For a detailed legislative history written by the provision’s authors, see Senator Jeff Merkley and Senator Carl Levin, The Dodd-Frank Act Restrictions on Proprietary Trading and Conflicts of Interest: New Tools to Address Evolving Threats, 48 Harvard J. Legis.515, 538, available at http://www.sec.gov/comments/df-title-vi/prohibitions/prohibitions-44.pdf.
 The Volcker Rule is contained in section 13 of the Bank Holding Company Act of 1956, as amended.
 The rule is implemented by the Federal Reserve Board, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, and our Commission and codified in several places, including at 17 CFR Part 255 for the Commission. See Federal Register version available at www.gpo.gov/fdsys/pkg/FR-2014-01-31/pdf/2013-31511.pdf.
 See Federal Reserve Board, Statement of Policy Regarding the Conformance Period for Entities Engaged in Proprietary Trading or Private Equity Fund and Hedge Fund Activities, 77 Fed. Reg. 33, 949 (June 8, 2012).
 Federal Reserve Board, Order Approving Extension of Conformance Period Under Section 13 of the Bank Holding Company Act, Dec. 18, 2014, available at www.federalreserve.gov/newsevents/press/bcreg/bcreg20141218a1.pdf.
 The Volcker Rule received bipartisan support, including from five former Treasury Secretaries. See Louis Uchitelle, Elders of Wall Street Favor More Regulation, New York Times, Feb. 16, 2010, available at http://www.nytimes.com/2010/02/17/business/17volcker.html; see also W. Michael Blumenthal, Nicolas Brady, Paul O’Neill, George Schultz & John Snow, Letter to the Editor, Congress Should Implement the Volcker Rule for Banks, Wall St. Journal, Feb 22, 2010, available at http://www.wsj.com/articles/SB10001424052748703983004575074123680183534.
 See, e.g., the Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). For descriptions of these programs, see, http://www.federalreserve.gov/newsevents/reform_taf.htm (reflecting $3.8 trillion in TAF loans), http://www.federalreserve.gov/newsevents/reform_pdcf.htm (for PDCF, reflecting $8.951 trillion in PDCF loans), and http://www.federalreserve.gov/newsevents/reform_tslf.htm (reflecting $2.319 trillion in TSLF loans, market value). See also e.g., Commercial Paper Funding Facility (CPFF), Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility (TALF). For descriptions of these programs, see http://www.federalreserve.gov/newsevents/reform_cpff.htm (reflecting $739 billion in CPFF loans and $738 billion in purchases of commercial paper), http://www.federalreserve.gov/newsevents/reform_amlf.htm (reflecting $217 billion in AMLF loans), http://www.federalreserve.gov/newsevents/reform_mmiff.htm (reflecting $0 in total loans as the MMIF facility was never used), and http://www.federalreserve.gov/newsevents/reform_talf.htm (reflecting $71.1 billion in TALF loans).
 See S. Comm. On Homeland Sec. and Governmental Affairs, 112th Cong., Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, 377 et seq (April 13, 2011) (hereinafter the PSI Wall Street Report).
 The Volcker Rule’s conflicts of interest provisions include section 13(d)(2), which ensures that permitted activities such as market making or hedging cannot give rise to a “material conflict of interest.” Section 621 of the Dodd-Frank Act added section 27B to the Securities Act of 1933, as amended. For more on section 621, see the Commission’s proposed rules and comments filed at the Commission’s website, respectively, www.sec.gov/rules/proposed/2011/34-65942.pdf and www.sec.gov/comments/s7-38-11/s73811.shtml.
 For more on Long-Term Capital Management’s collapse, see Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House (2001) and Richard Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, John Wiley & Sons, Inc., pp. 97-124 (2007). See also Report of the President’s Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (April 1999).
 Data on new U.S. corporate debt offerings are taken from Securities Data Corporation’s New Issues database (Thomson Financial). Data on new non-U.S. corporate debt offerings are taken from the World Federation of Exchanges monthly statistics reports.
 On an absolute basis, corporate bond inventories by dealers appear to be roughly similar to 2001, a point which is frequently ignored in the analysis of bond market liquidity. The size of the bond market overall, though, has grown significantly compared to 2001. Inventories have thus declined on a relative basis even more than on an absolute basis, leading in part to the increased perception of illiquidity. However, it is important to note that bond inventories have declined at the same time as asset managers’ holdings of bonds have grown dramatically. It is worth considering whether this is actually a positive development, where banks hold less risk and investors in bond funds hold more. See generally, Tracy Alloway, Digging into dealer inventories, FT Alphaville, Sept. 11, 2013, available at http://ftalphaville.ft.com/2013/09/11/1626462/digging-into-dealer-inventories/#.
 In addition, “liquidity” should not serve as a cover for firms taking large positions against their customers. The Senate Permanent Subcommittee on Investigations (PSI), in its report on the 2008 financial crisis, rejected the argument that the firms profiled were engaged in “market-making” with respect to selling synthetic collateralized debt obligations. The PSI concluded, rather, that the firm had taken large net short positions. See PSI Wall Street Report supra note 10.
 Yalman Onaran and Dakin Campbell, Did Bank Rules Kill Liquidity? Volcker, Frank Respond, BloombergBusiness, Oct. 20, 2014, available at http://www.bloomberg.com/news/2014-10-20/did-bank-rules-kill-liquidity-volcker-frank-respond.html.
 See, e.g., the Treasury “Flash Crash” of October 2014, which included illiquidity and its potential relationship to position-taking by large firms. The Treasury market is one of the most liquid financial markets in the world and is relatively unaffected by the Volcker Rule, yet it suffered what appeared to be a large disruption in liquidity on October 15, 2014.
 See generally, Committee on the Global Financial System, Market-making and proprietary trading: industry trends, drivers and policy implications, CGFS Papers No. 52, Nov. 2014, discussing monetary policy, market structures, and other regulatory changes. Corporate issuers have a role to play too. To the extent they value flexibility in issuance over facilitating secondary market trading, it will remain difficult to encourage the standardization that some believe is necessary to support more effective liquidity.
 See, e.g., James Felkerson, $29,000,000,000,000: A Detailed Look at the Fed’s Bailout by Funding Facility and Recipient, Working Paper No. 698, Levy Institute, Dec. 2011, at 33 (Table 17, noting 6 of the largest 14 recipients were foreign headquartered banks), available at www.levyinstitute.org/pubs/wp_698.pdf
 See generally Commissioner Kara M. Stein, Cross-Border Security-Based Swap Rules and Guidance, June 25, 2014, available at www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370542555426#.VN-Sby5cCMI.
 Information on the FBO rule is available from the Federal Reserve Board, available at www.federalreserve.gov/newsevents/press/bcreg/20140218a.htm.
 Martin Fackler, “In Japan, Financial Crisis is Just a Ripple,” New York Times, Sept. 19, 2008, available at http://www.nytimes.com/2008/09/20/business/worldbusiness/20yen.html?_r=0.