CAMBRIDGE, MA: 22 August 2013 - Three features of the Dodd-Frank Act — a massively long statute running over 2,200 pages long — would seem to invite various forms of gaming. First, the financial stakes and competitive implications for the domestic banking industry are undeniably huge. Second, some important features of this act are considered ill-advised and unwarranted by many bankers and members of Congress. (Only 3 Republican senators voted for the House Version of the bill.) Third, Congress chose to subcontract to federal regulatory agencies the actual writing of hundreds of new rules pertaining to key provisions of the Act. This legislative strategy predictably opened the pathway to full-throated lobbying by the banking industry as the regulatory rule-making process geared up.

The current rule-making process has already extended way beyond the two years originally envisioned for conforming to the Dodd-Frank Act — a result of the complexity of the issues involved, extensive comment periods of proposed regulations, aggressive industry lobbying, and the inability of regulatory agencies to agree on final regulatory language. According to Davis Polk & Wardwell, which closely follows the implementation of the Act, just 158 of the 398 required rule makings (or 40 percent) have been finalized nearly three years after Dodd-Frank was passed. During this delay the banking industry has naturally sought to win arguments at the regulatory level that were never addressed or resolved during the legislative phase. Bank officials and their representatives have not only tried to gain as much clarity and as many exclusions as possible in the new rules, but also to preserve maximum flexibility in regulatory compliance going forward. Congressional sponsors of the Act have also been working hard to ensure that the language of the new rules does not water down or otherwise subvert the intent of the legislation. Suspicions of gaming naturally led to snail-like negotiations and word-crafting.

On many of the Act’s provisions, bankers, financial economists, Congressional sponsors, and federal regulators have widely diverging views of what rules are called for and can be effectively implemented. One of the most highly contested rules is known as the “Volcker Rule”, championed by former Federal Reserve Chairman Paul Volcker.  


The Volcker Rule: Key Provisions and Regulatory Context

Known formally as Section 619 of the Dodd-Frank Act, the Volcker Rule is one of the law’s iconic provisions. It is also one of the act’s most complex provisions. Although Dodd-Frank devotes only 5,000 words to the Volcker Rule, Congress left plenty of leeway for regulators to design (bend?) how the final rule will look — as with so much within the bill.

The intent of the Volcker Rule is to prohibit banks from engaging in both commercial banking and investment banking, as the 1933 Glass-Steagall Act once did. Since a large part of investment banks’ business is now proprietary trading, which involves the purchase and near term sale of high-risk investments for banks’ own account, the intent of the Volcker Rule is to prohibit large, integrated banks from putting their federally insured deposits at risk by making risky investments for their own trading account. The rule also seeks to eliminate potential conflicts of interest between large banks and their customers.

In addition to prohibiting federally insured, deposit-taking banks from engaging in proprietary trading, the Volcker Rule also limits the amount of money (no more than 3 percent of a bank’s capital) that banks can invest in or use to sponsor hedge funds and private equity funds. The idea behind these investment restrictions is to eliminate the temptation of banking entities to bail out investors in troubled hedge funds and private equity funds, which are typically highly leveraged and can significantly expand a banking entity’s losses during a financial crisis.

In contrast to these prohibited activities, the Volcker Rule also expressly includes exemptions from these prohibitions for certain permitted trading activities, including “making a market” for the benefit of customers, risk-mitigating hedging activities, underwriting, and trading in U.S. treasuries, U.S. municipals, U.S. government agencies, and the paper of Fannie Mae and Freddie Mac.

These exemptions may seem simple enough, but the Volcker Rule as crafted by Congress does not precisely define important permissible activities. For example, market-making is permitted by section 619 to the extent that it is “designed to not exceed the reasonably expected near term demands of customers, or counterparties,” but this provision neither defines “market-making” as a banking activity nor offers a clear meaning of the phrases “reasonably expected” or “near term.” The lack of clarity between prohibited proprietary trading and permitted market-making has alarmed the banking industry. Many bankers argue that under normal trading conditions, there is often overlap between customer-oriented market-making and proprietary trading, especially in relatively illiquid credit markets where a simple matching of buyers and sellers is not possible. In such situations, maintaining a functioning market for bank customers in credit instruments and derivatives, along with equities, for bank customers frequently requires market makers to obtain positions in these securities in anticipation of customer flow. But under these circumstances, the market maker is necessarily exposed to changes in the value of the securities, and market-making begins to look very much like proprietary trading.  Is this permissible under the Volcker Rule?  

Authority for developing final definitions necessary to implement the intent of the Volcker Rule (and other rules under the Dodd-Frank Act) is shared by several regulatory agencies under the overall authority of the newly formed Financial Stability Oversight Council (FSOC), chaired by the Treasury Secretary. These agencies include the Office of the Comptroller of the Currency (Department of the Treasury), the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Federal Reserve Board, and the Securities and Exchange Commission. Dodd-Frank required FSOC to study the implementation of Section 619 and make recommendations to the five agencies responsible for Volcker Rule implementation within six months of the statute’s enactment. FSOC’s first action was a request, on October 1, 2010, for public input on the Volcker Rule. Approximately 8,000 comment letters were received, with roughly 6550 being identical letters arguing for strong implementation of the Volcker Rule. The remaining 1450 comments set forth individual perspectives from financial market participants, Congress, economists, and the public at large.

On October 11, 2011 FSOC released a highly complex, 298-page report, which proposed a variety of definitions and preliminary regulations and then posed more than 1,300 questions for comment by industry participants. FSOC asked that comment letters addressing the proposed rules and outstanding questions be submitted by January 13, 2012.

By the January 13 comment deadline, hundreds of banks, asset managers, business groups, American corporations, members of Congress, U.S. regulators, foreign regulators, and others submitted detailed letters addressing FSOC’s proposed definitions, regulations, and questions. A review of comment letters submitted by leading Wall Street banks, the Securities Industry and Financial Markets Association, members of Congress, and former industry executives reveals many persistent disagreements and concerns about the Volcker Rule. While the banks tended to accept the risk-reduction premise of the rule (namely, that proprietary trading on Wall Street should be placed outside the taxpayer safety net), they argued that the rule, in its current form, is too complex, too burdensome, and inconsistent with preserving the functioning of global trading markets. In the words of JPMorgan Chase, the “extraordinary complexity and large number of laws” in the Volcker Rule makes implementation impossible without imposing “unacceptable costs on our economy and financial system.”


Initial Debate over Regulatory Rule-Making

Underlying these broad criticisms are a broad array of more specific concerns. For example, in its 65-page comment letter JPMorgan Chase questioned, among many other matters, (1) the proposed definition of a “trading account,” — a seemingly minor matter but one which is absolutely critical to one’s understanding of what constitutes prohibited proprietary trading; (2) proposed criteria for defining and differentiating between proprietary trading and market-making; and (3) various proposed rules that inhibit effective asset-liability management, risk-mitigating hedges, and liquidity management — all argued by JPMorgan Chase to be central to safe and sound bank management. The bank also argued that FSOC’s assumption that banking entities will camouflage prohibited trading and work to evade and subvert the intent of the Volcker Rule has contributed to unnecessary complexity.  

The basic thrust of Goldman Sachs’ 63-page comment letter was that FSOC’s definitions of permitted and prohibited trading activities are so narrowly defined that they significantly limits banks’ capacity to help clients raise capital, manage their risks, invest their wealth, and generate liquidity for their holdings. More fundamentally, Goldman criticized regulators and rule-makers for their “totally out-of-date” conception of how financial markets work, one based on an antiquated agency-based, exchange-traded equities paradigm. In the current world of finance, Goldman argued, new illiquid assets abound, thereby invalidating the applicability of the regulators’ implicit, exchange-traded market model. In other words, being a market-maker in today’s world requires warehousing an inventory of securities in order to actually make a market—since for many securities there is simply no counterparty currently available, and therefore no price. Goldman claimed that if FSOC stays with the old conception of how financial markets work, the inevitably narrow and restrictive definitions of market-making would destroy market liquidity. (The Securities Industry and Financial Markets Association reiterated Goldman’s dire warning about the devastating effects on corporate liquidity in its 175-page comment letter.) According to Goldman, the inevitable result will be massive mark-to-market losses on bank and corporate balance sheets and an escalation of cumulative financial transaction costs into the hundreds of billions of dollars. The most promising way forward, Goldman argued, is to invest in developing quantitative “metrics” that could be helpful for indicating the true character of a trading activity — be it proprietary trading or market-making — and to avoid inappropriately restrictive definitions. The design and implementation of such metrics, Goldman argued, will require “robust and on-going dialogue between banking entities and their regulators. It will also require expanding the conformance period beyond the July 2012 start date." Whether this suggestion will be perceived as foot-dragging or gaming the implementation of financial reform remains to be seen.

Chairman Volcker’s comment letter argued that the market liquidity argument, put forth by Goldman and others, was way overdrawn: “There should not…be a presumption that evermore market liquidity brings a public benefit. At some point, great liquidity, or the perception of it, may itself encourage more speculative trading…” Volcker also rebutted claims that proprietary trading by commercial banks is not a serious risk factor, that the competitive position of U.S. based banking institutions will be adversely affected (as claimed by JPMorgan and Goldman), and that the proposed regulation is simply too complicated and costly. But Volcker did agree with Goldman’s call for meaningful metrics to help discriminate between permitted market-making and prohibited (and “deliberatively concealed and recurring”) proprietary trading. Volcker also recognized in his letter “the thorny issue of guidance” with respect to situations where market-making for customers takes on characteristics of prohibited proprietary trading. Since only a very few, large banks engage in continuous market-making on any significant scale, Volcker was nevertheless sanguine about the possibility of effective regulatory oversight.

Chairman Volcker’s concise letter, while seemingly balanced and non-confrontational, was not seen as such by Jamie Dimon, the chairman and chief executive of JPMorgan Chase. Dimon told Fox Business in a February 13, 2012 interview, “Paul Volcker by his own admission has said he doesn’t understand capital markets. He has proven that to me.” Dimon added, “I understand the goal to make sure these companies don’t take huge bets with their balance sheets. But market-making? Just like these stores down the street, when they buy a lot of polka dot dresses, they hope they’re going to sell, they’re making a judgment call. They may be wrong! So protecting the system I agree with, but starting to talk about the ‘intent’…I tell you… for every trader, we’re going to have to have a lawyer, compliance officer, a doctor to see what their testosterone levels are, and a shrink [asking them], “what’s your intent?” No, we’re going to make markets for our clients to give them the best products, the best services, the best research and the best prices. That’s a good thing in spite of what Paul Volcker says.”

One of the most remarkable comment letters came from John Reed, who held CEO titles at Citigroup and its predecessor from 1984 to 2000. Reed had helped engineer the merger between Citibank and Sanford Weill’s Travelers Group (owner of the investment firm Salomon Smith Barney) after the repeal of the Glass-Steagall Act, which had separated traditional banks from those involved in capital markets. He has since said that the repeal of Glass-Steagall was a mistake. In his comment letter. Reed recommended that the proposed Volcker Rule be made stronger by requiring regulators to change how traders are paid to prevent future abuse of the activities that the rule still permits, requiring quarterly CEO and top management signoffs on complying with the rule, and the imposition of “severe penalties” for non-compliance.

Eighteen months after all the requested comment letters were received by FSOC, it is still unclear how such disparate, strongly held views about the final rendering of the Volcker Rule will be reconciled. Hence the mounting impatience of the President and some members of Congress. Not only have various bank regulators been at loggerheads over such issues as distinguishing between permitted market-making activities and prohibited proprietary trading, but regulators have also been swamped with industry lobbyists seeking to water down the rule’s various provisions. The delay in implementing the Volcker Rule is palpable. In the words of Paul Volcker, “We passed a law, like it or not, and three years later, we’ve got no rule.”


Are New Rules Related to Proprietary Trading Being Gamed?

Gaming in the present context refers to deceptive (and often lawful) behavior that subverts the intent of socially mandated rules for private gain. Gaming contrasts with good faith negotiation of rules or good faith compliance with the spirit of established rules. When it comes to rule-making in the world of economic regulation, the distinction between deception and good faith negotiation lies in the motives of affected firms and their lobbyists. If companies and their lobbyists try to negotiate language and rules with regulators that leave open unintended possibilities for side-stepping the rule’s intent in the future, then such behavior can said to be a deception and a form of gaming. If, however, the motive were to clarify the meaning or scope proposed rules without pushing for loopholes that permit unintended evasion of regulatory or legislative intent in the future, then that would be a case of good faith negotiation rather than a case of gaming.

Game players typically try to rig society’s rules in their favor through largely invisible lobbying efforts. They also tend to follow the letter of the law but not necessarily its intent or spirit. They exploit — for personal or institutional gain — purposively grey areas of the law that are not easily understood or recognized as violations.

Gaming typically comes in two, trust-destroying forms: a rule-making game and a rule-following game.

The rule-making game is an influence game. It involves influencing the writing of society’s rules by legislative or regulatory bodies, so that loopholes, exclusions, and ambiguous language provide future opportunities to “work around” or circumvent the rules’ intent for personal or institutional gain. The rule-following game is a compliance game. It involves the exploitation of gaming opportunities created during rule-writing.

Since only 38 percent of the required rules under section 619 of Dodd-Frank have been written and agreed upon, it is difficult as of August 2013 to report any authoritative conclusions about the behavior of large banks with respect to gaming the implementation of Dodd-Frank in general and the Volcker Rule more specifically. For sure, during the legislative phase there was massive lobbying in Congress by financial institutions and their various associations in opposition to reform. While this lobbying did not prevent passage of the Dodd-Frank Act, it did succeed in significantly watering down the Volcker Rule as originally proposed. And during the continuing regulatory rule-making phase, the gray area between proprietary trading and market-making would seem to invite heavy influence peddling and lobbying — particularly with respect to definitions of permitted and prohibited activities creating exclusions and loopholes that could be exploited for private benefit in the future.

That said, during preliminary rule-making, which includes draft rules and related questions issued by FSOC on October 11, 2011 and the subsequent comment period for industry participants (ending on January 13, 2012), I have not been able to detect—sitting outside the lobbying process—any truly defining cases of gaming behavior that fundamentally subverts the intent of the statute, as opposed to good faith (and persistent) efforts to achieve clarity and ease-of-implementation in the final regulations.

For example, all of dozens of comment letters that I reviewed from the largest banking institutions and industry associations to the FSOC in January 2012 addressed specific regulatory questions regarding prohibitions or exclusions related to trading, market-making, and hedge fund investing in a substantive, largely technical manner. While most of these respondents were not supporters of the Dodd-Frank Act (although not totally adverse to some sort of financial reform), opinions and recommendations were typically substantiated by systematic analysis of financial function and supporting processes. In my review of invited comment letters, I detected no gross misrepresentations of fact or mischaracterizations of banking processes, although there was certainly room for substantial differences of opinion over the costs, benefits, and challenges of prohibiting certain trading functions under the proprietary trading restriction.

Of course, in preparing public letters of this sort there are no conceivable gains to be had from overtly self-interested, unsubstantiated arguments on the part of banks targeted for re-regulation. For this reason, we should not rush to any judgments about this laudable straightforwardness. Beneath this surface of comity and technical debate, and outside my field of vision, it is possible — and even likely — that a battle royal is being fought over the crafting of regulations in ways that would enable banks to lawfully sidestep some of the prohibitions or even subvert the intent of the Volcker Rule in the future. Indeed, the large amount of money being spent on lobbying by banking interests has hardly declined as the Dodd-Frank Act has moved from the legislative phase to the current regulatory rule-making phase. And given the significant financial stakes involved for large banks, we know that there are many incentives for banks to figure out ways of side-stepping prohibitions against proprietary trading by claiming such trading to be part and parcel of such permitted trading activities as market-making, hedging, or other customer-initiated transactions.

This gaming potential was clearly acknowledged in the January 2011 report by FSOC on proprietary trading. This report minced few words in acknowledging and describing the various ways in which banks could mask prohibited proprietary trading as market-making or risk-mitigating activities, thereby gaming the essential purposes of the Volcker Rule. In the same vein, U.S. Senator Jeff Merkley, the Oregon Democrat who with Senator Carl Levin, a Michigan Democrat, put the Volcker Rule into Dodd-Frank complained to Bloomberg in response to industry claims that the new proprietary trading rule would choke off liquidity in the markets, “The banks are using every strategy they possibly can to ‘confuse the issue’.”


What the Record Reveals

As far as predicting future gaming and circumvention is concerned, many opportunities exist. First, many regulations (and prohibitions) have yet to be written, inviting the normal sparring over substantive restrictions and language. Second, great uncertainty exists about whether or not the intent of financial reform can actually be adequately protected by the regulatory regime put in place by the legislative authors of the Dodd-Frank bill. This regime puts the onus of compliance on the banking entities themselves (a costly and complicated function requiring breakthrough methodologies). It also requires relevant government agencies to conduct robust oversight and enforcement (also costly and involving dispersed regulatory authority). The effectiveness of this regime will only be revealed in the coming months and years.

These disclaimers aside, what else can we say now about past and current industry efforts to shape and perhaps side-step the intent of the Volcker Rule?

As a start, we can say that lobbying and influence peddling remains robust as of the summer of 2013. All indications are that the energy and resources invested by industry associations and financial institutions in lobbying for favorable regulatory language have remained large and sustained. The industry has been heavily engaged in all aspects of the financial rule-writing through a wide variety of channels like the U.S. Chamber of Commerce, the Securities Industry and Financial Markets Association, the American Bankers Association, the Financial management Association International (for hedge funds), and the Financial Services Roundtable.

To complicate the problem, members of Congress have long received significant campaign contribution from the finance industry. According to the Center for Responsive Politics, a nonprofit organization that monitors political donations, the financial sector is one of the largest source of campaign contributions to federal candidates and parties. And according to Robert G. Kaiser’s detailed legislative history of the Dodd-Frank Act (Act of Congress: How America’s Essential Institution Works, and How It Doesn’t. Knopf, 2013), the watchdog Public Campaign Action Fund has calculated that members of the House Financial Services Committee (chaired by Rep. Barney Frank during the writing of the Dodd-Frank Act) received a total of $62.9 million from the financial sector from the start of their Congressional careers through the spring of 2009—an average of $885,000 per member. Kaiser also reveals that Chairman Frank received considerably more finance sector donations, totaling $,1,041,298 in 2007-08 alone. Frank’s co-author and collaborator, Chairman Chris Dodd of the Senate Banking, Housing, and Urban Affairs Committee, received $6,081,836 over the same period. We can safely assume that members of the Senate committee received comparable attention and care. Both Barney Frank and Chris Dodd have claimed that this campaign money did not influence their approach to regulatory reform, and that they have consistently supported reforms that large banks opposed. Still, as Kaiser observes, neither Dodd nor Frank ever proposed breaking apart the large banks or otherwise changing the fundamental structure of the banking sector.

With respect to lobbying, Marcus Stanley — legislative director of Americans for Financial Reform (a coalition of 250 national, state and local consumer, labor, investor, civil rights, community, and small business organizations) — claims that the financial industry spent $1.4 billion on lobbying to influence the legislative process in 2008-2010. In addition, according to The Economist, the financial services community deployed more than 3,000 lobbyists to influence the scope and content of the Dodd-Frank reform bill. That’s about 30 lobbyists per U.S. Senator. During the legislative phase of Dodd-Frank and the Volcker Rule, the influence game was rigorously played and, if the act’s mind-numbing complexity is any guide, responsive to many private interests.

After the passage of the Dodd-Frank bill, the financial sector maintained its level of spending on campaign contributions and lobbying. Lobbying-only numbers released by the Center for Responsive Politics, show that finance firms and trade associations spent collectively $96.8 million during 2012, only a little less than the amount that was spent in 2010 and 2011 when Dodd-Frank activity on Capitol Hill was most intense.

Immediately after the bill was voted, the “ground war” conducted by industry lobbyists shifted from Congress to on federal agencies like the Federal Reserve and the Securities and Exchange Commission, to which the act left the tough work of writing the actual regulations. According to Gary Rivlin of OpenSecrets.com, the infantry on the ground in 2012 included 183 lobbyists working for the U.S. Chamber of Commerce, 91 for the American Bankers Association, 60 for JPMorgan Chase, 51 for Goldman Sachs, 49 for the Securities Industry and Financial Markets Association, 28 for the Financial Services Roundtable, just to mention a few. To give a sense of relative “fire power,” the top five industry groups working to influence and bend Dodd-Frank to their interests fielded 406 lobbyists on Capitol Hill in 2012, versus 20 for the top five consumer protection groups defending Dodd-Frank — a 20 to 1 ratio. This ratio does not reflect the combined forces of regulatory lawyers, research staffs, PR people, friendly think tanks supporting the finance industry, and, of course, bankers themselves meeting face to face with federal agencies on dozens of occasions.

It should be no surprise that these motivated lobbyists are extremely well organized. According to detailed research of industry lobbying by Kim Krawiek, within hours of the bill’s passage in July 2010, big banks and industry trade groups systematically divided their teams of lobbyists into 18 work groups, each focused on different elements of the new law. One of these work groups focused on the Volcker Rule. In the words of Krawiek, “battalions of lawyers burrowed deep in the federal government to foil reform.” Whether that characterization is appropriate remains to be seen. But there is little doubt about the massive effort to influence regulatory language. Says Michael Barr, who was an assistant secretary at the Treasury Department during the writing of the Dodd-Frank bill, “You pick a page at random, and I’ll tell you about all the issues on that page where the fighting was intense.”


The “Big” Questions

How do we understand the full picture of how the Volcker Rule is being implemented and perhaps gamed? As the regulatory rule-making process grinds to its inevitable end, will the Act’s essential purposes be protected or successfully subverted? How will the pubic interest and legislative intent be interpreted in matters of highly technical securities trading? What exclusions, loopholes, and gaming opportunities will survive final rule-making? How will Wall Street’s largest banks choose to comply with the final provisions of Volcker Rule? How much trading with proprietary-type characteristics will actually be shut down?

With respect to proprietary trading by large banks, what we know so far is that Goldman Sachs — just to stay with this example — reported in its annual 10-K filing with the U.S. Securities and Exchange Commission that it liquidated during 2010 “substantially all the positions” in the principal-strategies unit that operated within the firm’s equity division. That was certainly a quick response to a first reading of the bill. In addition, the bank reported that in the first quarter of 2011 it “commenced the liquidation of the positions that had been held by the global macro proprietary-trading desk” within the fixed-income, currencies, and commodities (“FICC”) division.

We also know that Morgan Stanley was planning to break off its largest pure-proprietary trading group, Process Driven Trading, as an independent advisory firm by the end of 2012. Similarly, we know that executives from JP Morgan Chase, Citigroup, General Electric’s GE Capital unit, and Credit Suisse have met with Federal Reserve or U.S. Treasury Department officials on multiple occasions to discuss implementation of the Volcker Rule.

All of these examples are indicators of trust-building adaptation to changed circumstance. Still, important questions remain. Goldman, for example, which has publicly supported financial reform, has not entirely eliminated some businesses that make bets with its own capital. While Goldman states in its SEC filing that it “will continue to assess our business, risk management, and compliance practices to conform with developments in the regulatory environment,” we do not yet know whether or not it will lawfully transfer some of its remaining proprietary trading off-shore to its Global Macro Proprietary Trading Desk in London. Similarly, we do not know whether or not large banks will shift some of their traders to market-making or client-service desks—thereby enabling the bank to continue operating as before, albeit at diminished scale and visibility. Similarly, we do not yet know how large banks will respond to prohibitions on investments in hedge funds and private equity funds? Will they follow JP Morgan Chase in shedding its private equity operation? How will banks deal with new hedge fund restrictions? As noted in the first FSOC report, while a number of banking entities have shut down or plan to shut down dedicated (“bright line”) proprietary trading operations and hedge fund businesses that were a source of losses during the financial crisis, impermissible proprietary trading may continue to occur within permitted activities that are not organized solely to conduct proprietary trading.

We can only imagine the full range of questions pertaining to the implementation of Volcker Rule that remain for bankers and their regulators to clear up. And we can only imagine how much energy and resources the banking community will invest during the final rule-making phase in trying to preserve opportunities for lawfully practicing various forms of trading that contribute so much to banks profits. For this reason, continuing to follow the implementation of the Volcker Rule will help us better understand where and to what extent the Volcker Rule has been gamed, where it has been responsibly adopted and complied with, and how the remnants of gaming can be best contained in the future. There is no better test case by which to assess regulatory and industry behavior in the implementation of financial reform.

THIS PIECE WAS INITIALLY PUBLISHED ON THE EDMOND J SAFRA LAB FOR ETHICS PORTAL AT HARVARD UNIVERSITY (http://www.ethics.harvard.edu/lab/), WITH WHICH CLMR IS PARTNERED AND IS REPRODUCED WITH PERMISSION.