Why the new Volcker Rule will make it harder to assess risk

After years of controversy, the Volcker Rule finally came into effect at the end of 2013. The aim of the rule is to curtail the risk that banks can take with their own money, and to protect the economy from the impact of Wall Street recklessness.

Unfortunately, the rule contains several loopholes that can blunt its effect, allowing, for example, trades in government debt (think Greece – or Detroit), high-frequency trading, and hedging activities. This last one will actually make it harder for markets to assess the risk of bank portfolios under the Volcker Rule.

Broadly speaking, hedging is the activity of taking market positions to counter the risk of other positions. For example, a bank that has invested in oil-company shares might hedge by investing in airline stocks since a movement in the price of oil would send the prices of those stocks in opposite directions. Seldom, though, are hedges this simple or function this predictably. More often, banks will go long (buy) or short (sell borrowed securities, expecting they can be bought cheaper later) in many different industries at the same time. And they utilize complex financial derivatives in order to account for a variety of factors such as macroeconomic risk, sector dynamics, and individual company risk. In the above example, airlines might well get a boost from falling fuel prices, but new federal regulations could simultaneously depress those same stocks.

In addition, hedges themselves are often hedged, all leading to an interconnected and delicate web of financial bets that can come apart with a single miscalculation. That, in essence, was what led to the $6 billion London Whale loss for JPMorgan Chase in 2012.

In order to use the hedging exception under the new Volcker Rule, banks have to explain what they are hedging against. But given the vast portfolio of trading positions a major bank typically holds at any time and given the immensely complex structure of hedges, it will not be difficult for banks to classify proprietary trades as hedges against something or other, thereby turning a possibly risky trade into a risk-mitigating one. Staying with our example, a bank might short major restaurant chains because it expects food prices to go up, but that could also be construed as a hedge against an investment in airlines, which take a slight hit when food costs rise. More importantly, this shifts the focus from the inherent risk of trading in the restaurant business to a calculation about the trade-off between restaurant, airline, and oil company stocks – creating a forest that is bound to be missed for the trees.

A safeguard included in the Volcker rule is a restriction against taking “material” risks in hedges, but this, too, is unlikely to work as intended. The measurement of such risk, which the rule leaves open to interpretation by individual banks, is done through mark-to-market accounting, where the bank’s traders and third parties determine the value of a position. Traders, however, can mismark their positions because of miscalculation or because they are afraid to acknowledge a bad bet; while third parties can be just as easily flawed in their assessment of risk. The subprime mortgage crisis, for instance, was largely the result of mispriced risk by outside ratings agencies who rubber-stamped junk assets as high-grade.

Goldman Sachs has long followed the policy of using third-party corroboration for marks and JPMorgan Chase has recently switched to that method in the wake of the London Whale. But the reality remains that the process remains highly subjective and open to abuse.

The Volcker Rule is well-intentioned, but by including loopholes that banks and their attorneys can take advantage of to misrepresent risk, the cure could well turn out to be worse than the disease. By enabling banks to dress up risk-taking as risk-reduction via the hedging exception, continued leeway in marking trades according to a bank’s individual whim, and with no official standard for determining material exposure, the Volcker Rule will do little to curb Wall Street irresponsibility and make it harder for markets to assess the real risk of a bank’s trading activities.

– Political and business commentator Sanjay Sanghoee has worked at leading investment banksLazard Freres and Dresdner, as well as at multibillion-dollar hedge fund Ramius. His opinion pieces have appeared in Time, Bloomberg Businessweek, Fortune, and Huffington Post, and he has appeared on CNBC’s ‘Closing Bell’, TheStreet.com, and HuffPost Live.