Now that the five US financial regulators have signed off on the Volcker Rule, its unknown unknowns for corporate finance are going to start coming to light. Banks have until July 2015 to comply with the rule, and most have already eliminated big chunks of their proprietary trading and investment businesses. Those initial moves, and the rule’s final language, have hinted at three ways that Volcker could affect the world of corporate finance.
The first, and most concrete, is in underwriting. Banks will no longer be able to hold on to chunks of underwritten securities, which regulators will view as disallowed investments. Banks often manage the distribution of securities and support the aftermarket by employing their own inventory of the stocks and bonds they have underwritten as part of their service to issuers and to maintain their credibility with investors. This market smoothing and support activity will be harder to achieve with regulators pressing banks to unload inventories.
Second, banks argued during their lobbying effort against the Volcker Rule that a reduction in prop trading would hurt thinly traded markets, and have some negative liquidity effects on larger markets that could cause yields to rise. This didn’t carry too much weight with regulators since the thinly traded markets were usually those that regulators would love to see disappear anyway – such as off-the-run CDS. Other asset managers should step in, if yields rise, but since liquidity in the corporate bond market is low to begin with, it is unclear whether the banks’ dire predictions about secularly widening bond spreads will come true.
Finally, regulators want there to be a reasonable link between bank hedges and items being hedged, but they have not specified what they mean. JP Morgan says its whale debacle was a hedge, when it was clearly a speculative play. But most transactions aren’t such leviathans. Depending on the level of regulatory scrutiny that emerges, banks might be constrained in their attempts to hedge highly customized transactions for corporates and this could affect their price and/or availability.
It will be 18 months before these consequences become concrete, but with the final rules now approved, anecdotal evidence should begin piling up, giving treasurers an idea of what they’re in store for in the Volcker world.