Volcker Trims the Banking Hedge
Final Rule Could Force Banks to Think More Directly About the Risks They Are Taking On—and Not Just the Ones Investors Would Expect
Proprietary trades are often in the eye of the banker. And they don't always have to involve a group of traders placing high-stake wagers. Sometimes, they involve seemingly routine activities.
That is why the most important provision in Tuesday's release of the voluminous final version of the Volcker rule, meant to limit banks' ability to engage in proprietary trades, could be the inclusion of a ban on so-called portfolio hedging. This is when a bank tries to protect itself from an unspecific risk, a so-called Black Swan event.
Debate over whether such a provision should be included has swirled for some time. Although not included in the first version, it emerged last week that such a ban likely will be there amid a push to stiffen the rule's provisions.
Banks have argued against this, saying it would limit their ability to avoid getting sideswiped by unforeseen risks. There is some logic to this given how exposed the biggest institutions are to macroeconomic and global market forces.
Yet the sometimes amorphous nature of the threats portfolio hedges aim to protect against opens the possibility that they are simply proprietary bets in disguise. What's more, their existence may lull banks into thinking they can always minimize the risk of certain actions, or undertake ones that look matter of course yet are themselves proprietary wagers. And such hedges can, in any case, prove ineffective or simply blow up in a bank's face.
In that sense, J.P. Morgan's JPM +0.80% "London Whale" trade, which ended up costing it more than $6 billion, is instructive. The bank said in the wake of the debacle that the trades, which involved it placing bets using credit derivatives, wouldn't have fallen afoul of the Volcker rule. Regulators have since indicated they want to make sure this won't be the case, hence the decision to include a ban on portfolio hedging.
Perhaps most telling about the Whale, though, is what led to its creation. Awash in deposits with few options to profitably redeploy them due to slack lending growth, J.P. Morgan bulked up on corporate bonds. Its holdings of these securities as a percentage of its investment portfolio was more than four times that of peers Bank of America BAC +0.13% and Citigroup C +1.20% and 17 times levels seen before the financial crisis.
While not a proprietary trade in the traditional sense, it was nonetheless a bet on a particular market. And it led J.P. Morgan to try to hedge, through credit derivatives, the risk that some global event could cause a corporate meltdown.
Granted, J.P. Morgan may have taken this gamble regardless of whether it was able to try to hedge it. But if it hadn't been able to do so through portfolio hedging, the bank may not have reached quite so far. Or it may have taken a smaller overall position if it had to hedge individual securities, which likely would have proved more expensive.
Others have also been lulled into a false sense of security by thinking that broad-based hedges can protect them from what end up being outsize bets on a particular market. During the financial crisis, for instance, banks found that their broad hedges of portfolios of so-called Alt-A mortgages, or those that fell between the designations of being prime or subprime, weren't nearly as effective as they had thought.
Just how the Volcker rule limits banks' room for maneuvering in such areas will depend on the final language related to portfolio hedging. The fact a ban is there, though, should force banks to be more particular about the risks they take—even when they aren't swinging for the trading fences.