Why Canada hates the Volcker Rule

The landmark U.S. financial reform imposes high costs north of the border, say Canadians. Americans don’t think so.

Former U.S. Federal Reserve Chairman Paul Volcker. (Jonathan Ernst/Reuters)

In his speech at Harvard University this week, Deputy Governor of the Bank of Canada Timothy Lane took aim at the very cornerstone of Obama’s 2010 landmark financial reform bill. And then he shot: Canada, he said, does not “agree that the Volcker Rule is the only — or the most effective way to prevent excessive risk-taking in financial institutions.”

After everything that happened in the U.S. with the financial crisis — and everything that didn’t happen in Canada thanks to our prudent approach to financial regulation (no bank bailouts, no housing crisis, no massive job-destroying recession), you’d never expect Canadian officials to be so vocally opposed to efforts to tighten oversight of the financial markets south of the border. But they are.

The Volcker rule, named after former Federal Reserve chairman Paul Volcker, is a complex piece of financial regulation that aims at preventing large banks from putting customers’ money at risk.

That sounds good — except the legislation imposes a number of rules on Canadian banks too. Very costly, restrictive and unnecessary rules, according to critics on this side of the border.

Article III, section B of the current draft of the Volcker rule forbids U.S. banks with retail customers and access to government-backed deposit insurance from engaging in “proprietary trading”— that is, carrying out trades for their own profit rather than just acting as intermediaries. The rule also prohibits banks from owning or managing hedge funds, under the presumption that such funds would be more likely to take on excessive risk.

The trouble is, the Volcker Rule applies to the U.S. operations of all foreign banks as well and even purely foreign operations that happened to use U.S. financial infrastructure (think things like U.S. stock exchanges, mutual and money market funds or bond trading firms like PIMCO). As things stand right now, Canadian banks would have to comply with it in order to carry on with their business in the States.

And that’s rather tricky, given how interconnected Canadian and American markets are. “Our U.S. activities consist of either insured depository institution subsidiaries or direct U.S. uninsured wholesale branches or agencies or both with a total combined amount of $659 billion in banking assets as of September 2011,” the six largest Canadian banks pointed out in a joint comment letter filed last year. These branches allow Canadian banks access to American exchanges and financial infrastructure, which also connect them with Canadian clients and intermediaries in Canada. Sources working in legal services for the Canadian banks told Maclean’s  it would be difficult for Canadian banks to determine whether or not they are violating the Volcker rule, as many transactions taking place wholly in Canada could have various U.S. connections through subsidiaries and U.S. infrastructure.

Another major concern is that the Volcker rule’s ban on proprietary trading provides an exemption for U.S. government bonds, but not for non-U.S. government bonds.  Put simply, U.S. banks and U.S. branches of Canadian banks would no longer be able to buy and sell Canadian government bonds as easily as before, potentially reducing the volume of new Canadian bonds circulating through the financial system.

“The restrictions on U.S. banks’ participation in the market for Canadian government securities would restrict competition and liquidity in these markets and ultimately undermine the resilience of the Canadian financial system” wrote Bank of Canada Governor Mark Carney last year, arguing that this approach would lead to a “fragmentation of global capital markets” if it were adopted by all countries.

Canadian critics fear this could end up raising borrowing costs for Canadian companies, municipal authorities and the federal government. According to Statistics Canada, U.S. investors purchased 73 per cent of all foreign-bought Canadian securities in 2011, and 71 per cent of all foreign-bought securities in the first two quarters of 2012. If the Volcker Rule impedes U.S. investors from buying Canadian bonds and makes it harder to use U.S. financial infrastructure, some fear that it will reduce overall demand for those bonds, causing the interest rates, or “yields”, on them to rise.

For a number of provincial and municipal governments that have been racking up increasingly large deficits in the last few years, the prospect of no longer being able to easily sell their debt to large U.S. banks is troubling. Though American banks would still be able to act as middlemen, they would no longer be able to buy up excess amounts for their own accounts.

Critics of the Volcker Rule also fear that the proprietary trading ban will hurt the liquidity of Canadian government bonds. Currently, the high volume of Canadian bonds in circulation means they are viewed as “safe” and “liquid” assets, meaning that financial institutions can sell them quickly when they need cash in a hurry.  The concern is that reduced U.S. bank involvement in the Canadian bonds market will reduce the speed and reliability with which these bonds can be sold, which could have knock-on effects for Canadian financial institutions that use them for this purpose.

As Finance Minister Jim Flaherty put it last February, the Volcker rule in its current form “could severely impact the liquidity of Canadian government debt markets and interfere with the risk management practices of Canadian banks.”

In the U.S., however, many are shrugging off these concerns. Even if the Volcker Rule disrupted Canadian and American banks’ conventional trading operations, “specialty U.S. fixed income firms will step in to trade them,” says bond market analyst and Multiple Markets founder Cate Long. “If there is profit to be made trading, there are many avenues to get it done.”

She thinks the proprietary trading ban would have little effect on the value of Canadian bonds and thus Canadian borrowing costs, as the practice of selling them to benefit from major short-term price movements is very common: “I think there are few firms that would hold sovereign securities for long. Money is made in infinitesimal amounts through trading the bonds a lot.”

Bart Naylor, a financial policy expert for the consumer advocacy group Public Citizen, feels much the same way. “If these markets are real, a fall in volume [of bonds sold] should shortly be reflected in price,” he said in a phone interview from Washington, D.C. “Any mismatch between buyers and sellers [caused by the Volcker Rule] can be addressed by market makers. And any number of firms can replace banks that exit a market, such as hedge funds. In fact, a few of them have spoken up — but many presumably remain quiet as they depend on banks for credit and prime brokerage services.”

For now, the world is still waiting to find out what form the Volcker Rule is going to take. The legislation has been embroiled in a painstaking rule-making process since this time last year. U.S. regulatory agencies usually seek comment from the public—including major foreign entities deemed affected— after publishing draft legislation. In this case, they have received over 18,000 comment letters thus far, and missed several deadlines to produce final versions of the rule. The latest target date is the end of April this year, though it’s uncertain whether that will be missed as well.

Canadian critics of the Volcker Rule, needless to say, have been eager to send their comments Washington’s way.

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