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The Volcker Rule Isn?t Being Diluted

By Anonymous

I want to smack down this particular bit of misinformation before the regulators release their proposed Volcker Rule, so that they don?t get hammered for absolutely no reason.

Last week, the WSJ ran a story claiming that a draft version of the regulators? proposed Volcker Rule would substantially weaken the original law, because the draft rule defines ?hedging? on a ?portfolio basis.? The problem with this story is that it?s 100% wrong. From the article (emphasis mine):

At issue is how regulators and banks define ?hedging,? or trades designed to offset risk taken by a bank, usually on behalf of customers.

The law originally defined hedging narrowly as trades tied to specific bets.

Actually, no. The law did NOT originally define hedging narrowly as trades tied to specific bets. Here?s how the law defined ?risk-mitigating hedging activities,? which are exempt from the prop trading ban (emphasis mine):

?(C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.? (Dodd-Frank § 619(d)(1)(C))

As you can see, it was the original law that defined hedging on a portfolio basis. This means that the regulators had no choice but to define hedging on a portfolio basis ? the regulators are simply interpreting and fleshing out the original law, and the original law said that banks can permissibly hedge on a portfolio basis.

The law said that the hedges have to be ?designed to reduce specific risks,? but risks can be ? and, in fact, almost always are ? faced on a portfolio basis. Interest-rate risk, for example, is typically measured and hedged on a portfolio basis ? banks don?t hedge the interest rate risk on each Agency MBS they hold in inventory individually, because that would be horribly inefficient; instead, they measure the interest-rate risk of their entire Agency MBS portfolio, and hedge that. (And in reality, this ?specific risks? limitation is meaningless anyway, because if a transaction wasn?t designed to reduce a specific risk, then it wouldn?t be a ?hedge? in the first place, now would it?)

So, clearly, the original law explicitly stated that banks are allowed to hedge on a portoflio basis. The fact that the regulators? draft rule allows banks to hedge on a portfolio basis does not weaken, dilute, or otherwise change the scope of the Volcker Rule one bit.

Full post as published by Economics of Contempt on September 25, 2011 (boomark / email).