Nom de Plumber | Volcker Rule implementation: Mission Impossible?

Below follows the latest from Nom de Plumber on the act of full display public idiocy known as the Volcker Rule. The American Bankers Association and Community Bankers have apparently backed down regulators when it comes to small bank holdings of preferred CDOs. But what is really needed is a loud “Foxtrot Oscar” to regulators on the entire enterprise. The Volcker Rule is artibrary and capricious. As Nom de Plumber argues, you cannot enforce a legal standard that cannot be accurately measured. One man’s hedge is another man’s principal exposure. The Volcker Rule is public evidence of the irrational madness that passes for serious thought in US public policy circles. — Chris

Volcker Rule implementation: Mission Impossible?

A hedge at a bank will be deemed allowable risk mitigation, and not forbidden proprietary trading—–but only if no material new risk arises, unless the hedge simultaneously protects against that too. Yet, in reality, every hedge does NOT eliminate risk, but merely exchanges one risk type for ideally more-palatable risk types. For instance, a bank could hedge the market risk of its Treasury bond portfolio, by shorting Treasury futures. The bank thereby assumes these substantive new risks, instead:

* basis risk (cash versus futures tracking error)

* liquidity risk (margin calls, without offsetting asset cashflows)

* counterparty and operational risks ( http://www.bu.edu/econ/files/2012/01/Bernanke-RFS.pdf )

* regulatory risk (topic here, ironically).

So, how can any hedge truly be Volcker Rule-compliant?

To prove having only client market-making and no proprietary exposures, a bank must attribute its daily trading P&L to particular risk factors (yield curves, prepayments, defaults, credit spreads, equity indices, dividend streams, option-implied volatility, IRR, asset cashflows, currency rates, etc.) and buy-sell activity. It must then report all un-attributable P&L to regulators, for flagging non-client, proprietary risk positions. Yet, in reality, almost every asset (except non-callable, fixed-rate, high-quality sovereign debt) trades strictly by market price……not by observable or consensus settings of underlying risk factors. Because infinite permutations of risk factor movements can cause a specific asset price movement, no definitive anchor points will arise to bootstrap that mandated P&L attribution.

So, how can a bank or regulator attribute daily P&L, to flag proprietary trading versus client market-making?

Bottom line: The Volcker Rule will be remarkably hard, at best, to implement.

Moreover, a bank complying with Dodd-Frank originator risk retention could simultaneously be charged as a disguised version of non-compliant proprietary trading.

http://mortgagenewsclips.com/2011/07/14/dodd-frank-conundrum-can-lender-…

Thank you.