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Why Volcker Rule Needs a Fillip

Experts believe Paul Volcker’s resolve to restrict banks from funding hedge funds doesn’t go far enough and needs to be emboldened

“Hedge Funds’ dependence on bank funding as part of their prime brokerage relationship is putting a huge burden (estimated at $ 1.5 trillion) on the banks’ balance sheet, which unfortunately has not been corrected in the new regulation,” laments CEO George Ugeux, calling for strengthening the Volcker Rule that he says is falling short in optimally dissociating banks from hedge funds thereby rendering the initiative mostly ineffective.

Writing in an Op-Ed at Huffington Post, Ugeux, CEO of Galileo Global Advisors, a NY based business advisory firm, says although Paul Volcker has been working to dissociate the speculative risks of hedge funds from banking, “this new rule does not go far enough in restricting banks from funding hedge funds . . . it needs to do more,” opines Ugeux.

Experts believe instead of depending on banks, hedge fund groups should seek financial assistance from other sources. They argue that if banks can save money – which otherwise would have gone to hedge funds – they can utilize the same in salvaging several of the tottering small business enterprises.

Ugeux believes if hedge fund groups borrow from the capital markets it’ll be mutually helpful to both parties – the banks and the hedge funds. Firstly, it’ll help banks free up some liquidity, positioning them to grant more loans to SMEs and consumers.

“I suggest that hedge funds get most of their funding from capital markets,” he says.

Additionally, by transferring their hedge fund exposure to the capital markets, banks will not need to increase their capital, even under the Bale III new rules, since they will have deleveraged their balance sheets.

“Hedge funds are fundamentally well placed to issue bonds on the fixed income markets and, once established, can find most of their funding from that source,” Ugeux points out. 

However, since hedge funds cannot operate only on bond financing, experts point out, authorities should restrict bank funding to a maximum limit of 25 percent. Additionally, the banks should not be exposing their assets beyond 5 percent of their value to hedge funds as against the 10 percent slab envisaged by the Volcker rule provisions.

If adopted, these measures will limit the banking sector’s exposure to the specific risks of hedge funds. Accordingly, Ugeux wants all these measures to be brought under the purview of the new ‘Volcker Rule,’ which will not only streamline the funding process but also ensure greater transparency.

Interestingly, David C. John, Senior Research Fellow in Retirement Security and Financial Markets, Heritage Foundation, feels Volcker rule is not the solution to reducing financial risk.

Blatantly writing off the Volcker initiative, John says prohibiting banks from engaging in certain types of financial activities is an old and discredited concept that was once embodied in the Glass-Steagall Act of 1933, which eventually ended up increasing financial risk rather than decreasing it after its repeal in 1999.

For its success, Volcker rule needs to be defined very precisely for regulators to implement it. “If definitions are loose, the rule would be essentially meaningless; overly restrictive definitions, on the other hand, would ban traditional ways that banks serve their customers and manage their assets to ensure that they have sufficient liquidity,” John points out.

“Policymakers should instead reduce systemic risk through increasing capital and liquidity standards and adopting a new bankruptcy chapter that could facilitate a realistic and permanent resolution of troubled financial services,” John wrote in an article for the Heritage Foundation.

Additionally, commenting on Volcker Rule flaws, Reuters columnist Felix Salmon enlists two fundamental flaws with the new rule. He says since the Volcker rule seems to apply only to depositary institutions (if you don’t take deposits, then you’re exempt), it will be easy for Goldman Sachs and Morgan Stanley to get around the rule just by returning their current (tiny) deposit base and voluntarily withdrawing from access to the Fed’s discount window.

Secondly, he says, it seems that banks might be allowed to continue to own hedge funds, private-equity funds, money-market funds and the like, just so long as they’re run for clients, with client money, rather than being vehicles for the investment of the bank’s own capital.

“This is dangerous, because the history of the financial crisis is clear: Bear Stearns ended up bailing out its internal hedge funds even when it didn’t legally have to,” he says, adding that although Volcker rule is a good idea, it has already been diluted to a point at which it will do very little good.

“If prop trading is a problem, it’s much more of a problem at Goldman Sachs than it is at Wells Fargo – yet the Volcker rule would apply to Wells Fargo and not to Goldman Sachs. Similarly, if owning hedge funds is a problem, it’s a problem whether or not the bank’s capital is nominally invested in the fund, but the Volcker rule gives banks an easy way to wriggle out from under it, simply by withdrawing their own investment.”

About fayazuddin a. shirazi