By Brai Odion-Esene

WASHINGTON (MNI) – As work continues in fine-tuning the Volcker
Rule, maligned as excessive or lauded as required to rein in banking
excess, U.S. regulators will ensure banks are free to continue
legitimate market-making activities, Federal Reserve Board Gov. Daniel
Tarullo said Wednesday.

Testifying alongside heads of the CFTC, FDIC, OCC and SEC at a
joint hearing of two subcommittees of the House Financial Services
Committee, Tarullo also spoke of the threat still posed should a large
firm fail, warning of consequences for the financial system.

The Fed will monitor whether or not a financial institution is
engaged in market-making activities.

“We at the Fed are going to make sure that we have a pretty
centralized way of looking at what’s going on at all of the major
firms,” Tarullo said.

Asked by ranking member Barney Frank, a Massachusetts Democrat, if
the Fed intends to protect legitimate market making, Tarullo replied “Of
course, absolutely.”

As the bank regulators accumulate more data, Tarullo said they will
be “substantially better positioned” to draw a distinction between what
is considered to be proprietary trading, and what are legitimate
market-making activities.

“It is important to note that what market-making consists of in one
kind of market, say for corporate bonds of Fortune 500 companies, is
different from what market-making may be in the case of a less traded
instrument,” Tarullo said.

“We are going to need data that distinguishes among those different
markets in order to oversee this rule effectively,” he added.

Tarullo also countered that while proprietary trading was not at
the core of what led to the 2008 financial crisis, “one is always
enjoined not to fight the last war as one goes forward.”

With regards to how the Volcker Rule and new risk retention
requirements will co-exist, Tarullo said, “Volcker rule enforcement
would take as given whatever the requirements of the final rules on risk
retention would be and would try to ensure that there not be any further
constraint on securitization beyond what those rules or other exogenous
rules would require.

“The aim is to make sure that you don’t have some incremental
inhibition upon securitization beyond what rules are, by their own
nature, intended to do with respect to regulating securities,” he added.

“The intentions with respect to the underwriting exception are
quite clear,” Tarullo said, “to make sure that underwriting can continue
to be pursued as appropriate.”

Asked if he believed proposals contained within the Volcker Rule
will negatively impact liquidity in the corporate bond markets, Tarullo
said there will probably be some incremental effect on liquidity in some
markets at the margin.

This, however, will depend on how well regulators ensure
market-making is preserved, and the degree to which non-regulated firms
pick up proprietary trading, such as hedge funds, “who see new market
opportunities.”

Tarullo said when regulators examine all the public comment
received, they can assess whether they need to adjust the proposed rule
at the margin, make some significant changes without fundamentally
affecting the structure, or change the structure completely.

“I think what will happen is once the comment period is ended …
we’ll need to make an assessment as to which of those three categories
we are in,” he said. “If we were in a category in which we thought we
had to change the basic approach, then one would expect that a
re-proposal would probably be what you’d do.”

On the other hand, if only adjustments to the basic approach are
required, “we may well not feel the need to re-propose the regulation as
opposed to making changes that then go final,” Tarullo added.

Commenting on the still unresolved issue of too-big-to fail,
Tarullo said there will be major consequences to the financial system
should a major financial institution fail, even if it was wound down by
the FDIC in a manner that does not require taxpayer funds.

“Financial instability and harm to the system can result even if
you are not in a position of bailing out a firm,” he warned.

That is part of the thinking by regulators as to how to move
towards more market discipline and — in an anticipatory fashion —
mitigate the consequences from the resolution of a major financial firm.

And to ensure that U.S. firms required to follow additional rules
are not at a competitive disadvantage compared to the rest of the world,
Tarullo said emphasis is on making sure other nations adopt Basel III
and implement the capital standards within their banks “in a rigorous
fashion like ours.”

** Market News International Washington Bureau: 202-371-2121 **

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