Volcker Rule

As part of the financial regulations reform , the US government is proposing the Volcker Rule named after the former Chairman of the Federal Reserve Bank. The proposed Volcker Rule prohibits banks,including investments banks such as Goldman or Morgan Stanley from taking proprietary positions or from trading derivatives.

This appears to be a rather radical step.I can understand banks who accept public deposits being prohibited from doing so.However if you do not accept public deposits or do not receive the shelter of the umbrella of the bank holding
company , then institutions should be allowed to trade for their own account.

The concern is the unraveling of the counter party risks as happened during the LTCP or Lehman situations where default by one institution lead to a domino effect.

I would argue that all derivatives should be exchange traded. While there has been intensive coverage of the losses of institutional investors who should have known better, very little coverage has been given to customers who were incited to invest in structured derivative products by their private bankers. Based on contacts in the private banking and friends, I know that private banking customers ( at least in Asia ) have lost a significant portion of their net worth by investing in these products.The only way out for them was by selling back to the bank - maybe ( who had sold them the product) at a price which they determine - and you thought only casino's have a house advantage !!

Also there should be a limitation on the size of the proprietary books as a percentage of their capital. After all the risk managers at the counter party banks, if they monitor their exposures carefully, will not ( or should not )allow them to exceed the equivalent of a single borrower/counter party limit.

The auditors and the regulators should insist ( subject to strict punishment) that these institutions clearly report the size of the proprietary books and the number of counter parties and the geographies they deal with.

Similarly the rating agencies in their evaluation should take this into account.

This by itself would imply a health warning for institutions who deal with them.

On the other hand if these institutions then choose to take positions on equity, commodities etc for their own books, let them do it. Their shareholders know what they are buying into. Caveat Emptor