NEW YORK (The Deal) -- Federal Reserve chairwoman Janet Yellen on Tuesday refuted assertions by Republicans that the Volcker Rule - written to prohibit big bank speculative proprietary bets - would limits efforts to manage risk and would hurt the U.S. economy.
"Banks will be able to go on to engage in activities, particularly market making and hedging, that are really vital to a functioning financial system," Yellen told lawmakers at the House Financial Services Committee, in her first hearing before Congress since becoming chief of the central bank Feb. 1.
The Volcker Rule is a key part of reform legislation drafted in response to the 2008 financial crisis and was enacted in 2010. The legislation is also fashioned to force financial institutions to cash out most of their hedge fund and private equity investments in the coming years. The 900+ page rule, named after former Fed chairman Paul Volcker, was adopted by the Fed and four other agencies in December. Volcker first suggested the concept for what eventually became the rule, when he was chairman of President Barack Obama's economic recovery advisory board.
Critics at the hearing, including Rep. Bill Huizenga, R-Mich., brought up concerns raised by bankers that firms and regulators will have a difficult time differentiating between legitimate market-making actions and prohibited speculative transactions. Banks have market-making obligations to provide liquidity to investors particularly in times of stress, as they did during the flash-crash that rattled the markets in 2010. Big banks provide this liquidity by buying, selling and holding securities and anticipating future customer demands. Opponents on the left have raised concerns that the Fed will permit dangerous speculative trades that are masked as permissible hedging of customer positions.
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Regulators have indicated that they will be taking a case-by-case approach to identifying what is permitted and what is prohibited and that banks will have more clarity about the trades over time.
Huizenga warned, however, that the Volcker Rule is driving liquidity from the U.S. He urged Yellen to set a finite review period for the regulation, adding that regulators should take some action quickly to respond to the damage he believes the rule is causing.
"How long will we see liquidity leave the U.S. and us lose market share?" asked Huizenga.
Yellen refused to set a deadline for reviewing the Volcker Rule's impact, arguing that "it certainly will take time to see what the effects of the rule are." Under pressure from Republicans, she acknowledged that proprietary trading was not the "main" cause of the 2008 crisis, but she didn't expand on the extent to which it contributed to the meltdown. She added that the Fed will work with other regulators to supervise and make sure banks comply with the rules.
In addition to backing the Volcker Rule, Yellen also raised the possibility that the Fed could require banks to hold "contingent capital," a special form of capital that acts like a bond in good times but converts automatically into common equity in a crisis. Supporters of contingent capital, also known as "bail-in" capital, argue that requiring banks to have the special debt could stabilize the economy during a crisis by providing healthier big banks with an easy and fast way to recapitalize through an injection of common equity, without involving taxpayer-funded bailouts.
However, she also indicated that the central bank hasn't worked out the circumstances under which the debt would convert to equity. Regulators would need to consider whether big banks could decide on their own to do the conversion or leave it up to the Fed or other government agencies to trigger the change. Under what circumstances government officials would call for a switch is another consideration, as is which big banks would need to hold the capital.
"There are a number of issues associated with that kind of debt and what would trigger it and so forth and it remains an interesting possibility," she said.
Yellen made the comments as part of a larger discussion with Rep. Patrick McHenry, R-N.C., over the Fed's expected plan to propose a rule soon that would require banks to hold a certain amount of long-term debt. This expected proposal is part of the Fed's effort to ensure that big banks have enough capital to be dismantled, if they fail, in a way that does not cause the kind of collateral damage to the economy as Lehman Brothers did when it filed for Chapter 11 bankruptcy in 2008.