An Australian perspective on Volcker
The potential impact of the Volcker Proposal, released in October and targeted for implementation in July 2012, is a cause of much reflection by our Australian banks.
By Mike Codling, PwC Banking Leader.
The objective of the Proposal is a logical response following the GFC – to prevent regulated banks from using depositor funds to place large bets through their Markets activities.
But in a surprise to many, the Proposal has truly pushed the limits of US extraterritorial reach by prohibiting any proprietary trading activities that have a ‘US nexus’. This includes trades with US counterparties, and so will impact virtually every Australian bank trading desk.
The Proposal, thankfully, does recognise that taking some market risk is necessary for essential trading, such as customer-driven activity and market-making. However, what is disconcerting is the ‘burden of proof’ required to differentiate these acceptable trading activities from speculative proprietary trading.
There may be up to 17 new quantitative metrics required daily at a desk level to demonstrate that trading desks are engaged in acceptable activity. Further, banks will need an ongoing reporting, governance and compliance structure that assigns accountability and responsibility to the board.At a time of unprecedented regulatory change on multiple fronts facing the banking industry, it’s a challenge to understand the impact of each individual new rule and their interconnectedness. Having said that, it seems clear that the Volcker Proposal could have some significant implications for the Australian banking system.
Operating costs in Markets businesses will increase significantly. The US regulators’ own estimates are that banks will spend 6.6 million hours in implementing the Rule, with more than 1.8 million required every year in perpetuity. While it is conceivable that the global investment banks can absorb such costs, the Markets businesses of Australian banks are much more focussed on customer-driven activity, and the compliance costs are going to hit far harder in relative terms.
Global regulatory differences will alter who Australian banks trade with. We sense a real risk of different regulation emerging across the globe. Already, the UK through its Independent Commission on Banking, is applying a different lens and proposing measures to ring-fence, but not prohibit, investment banking operations from retail banking operations for funding and capital purposes. In Asia, the regulatory direction in key locations remains unclear. It could be that we see Australian banks further shifting their trading towards less regulated geographies as liquidity in these markets increases.
The cost of foreign debt funding will increase. All Australian major banks rely on wholesale term debt in foreign markets as a key funding source. In almost all cases, they swap the foreign funding to Australian dollars through cross-currency swaps. Due to the large size of individual debt issues, the majors tend to build up foreign currency positions in the lead up to a foreign debt raising to minimise the (otherwise inevitable) swap fee ‘hike’. Under Volcker, this form of inventory (and risk) accumulation is unlikely to be seen as legitimate activity, leading to an increase in the average cost of wholesale borrowing for our banks.
Risk in the financial system will shift to unregulated entities. Paul Volcker himself, in the Australian Financial Review, November 18 recognised that the ‘shadow banking system’ – the non-depository banks, hedge funds, and other unregulated entities – was one of the key risks during the GFC. Ironically, the Proposal will reduce the level of market risk inventory held by regulated banks, thereby reducing derivatives liquidity for both the Australian majors and corporates, and most likely the ‘shadow banking system’ will fill the liquidity vacuum. This shift in risk from regulated to unregulated entities is already drawing some criticism of the Proposal.
There may be less unexpected trading losses in regulated banks. One positive outcome from the Proposal – particularly from a board and executive standpoint – is that some of the quantitative measures proposed by Volcker should help senior management more deeply understand individual trading businesses and risk-taking activity. These measures could reduce the now familiar rogue trading / unexpected trading loss event that comes about every few years (for example, SocGen and UBS in recent times). In almost all cases, the post-mortem of these failures has suggested that a more granular understanding and analysis of desk income would have helped in early detection.The comment period on the Proposal ends in January 2012. We have to doubt whether the July 2102 deadline can be met given we expect the rule-makers will need to consider hundreds of comment letters. It’s not entirely clear what will eventually transpire.
There is no doubt the Volcker Rule and its far-reaching application across the world comes at an extraordinarily pivotal time as the balance of global power accelerates towards the East. In its current form, the Proposal threatens to alienate the US as a financial powerhouse if other regulators do not adopt a similar stance. While it is inconceivable to trade in global financial markets without the US as a counterpart today, would that be the case in 2020?
Given the strength of the US banking response opposing the Proposal, many believe the Volcker Rule may not get up at all. But we believe – given the equivalent moves in the UK and rumblings in Europe – that some form of restriction or further governance will come to pass. And we won’t be immune in Australia.
This is yet another example of regulatory change not merely driving compliance activity but necessitating a strategic response. Hence the depth of reflection by our banks.
Mike was joined by Yura Mahindroo, a Director in PwC’s Risk Advisory practice.
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- Banking
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- Mike Codling, mdavis@financialpublications.com.au
- Article Posted:
- December 15, 2011
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