Volcker Rule change inspires tepid optimism

By Emma Olsson | 2 July 2020

As the US startup community celebrates the recent Volcker Rule reform, some worry the change could impair the banking system as it recovers from recent market volatility.   

Sankar Krishnan, executive vice president and industry head, banking and capital markets at Capgemini, is positive about the change, announced on June 25 by the Federal Deposit Insurance Corporation (FDIC).

“Given the strength of the banks right now I think it’s great timing, not just for venture capital (VC) but also for credit funds,” says Krishnan.

“What we are excited to see is that [the change] creates investment strategies which can be deployed into both credit funds and VC funds, and other qualified opportunities.”

First introduced in 2008 to stop banks from engaging in proprietary trading and relationships with hedge funds and private equity funds, the Volcker Rule – part of the Dodd Frank Act – has faced gradual rollbacks since 2016. This most recent development involved a removal of the covered funds rule, which had prohibited banks from investing in VC funds, hedge funds and other forms of private equity. The modification will become effective on October 1.

While the latest reform does allow for hedge fund investment, Krishnan believes banks will be wary of such moves.

“From a regulatory perspective it frees things up, but it doesn’t mean everyone is going to jump into crazy stuff. Each of the asset lability councils and each of the banks will set their own internal metrics in terms of how to go about this. It also helps banks because there was this alternate economy that took over with lots of VCs getting into lending, so I think it actually improves that because right now banks who are better equipped to do that will now be able to get in and do it,” he says.

Krishnan believes the first wave of investments from banks will focus on low risk companies.

“Let’s say a bank wants to make a tie up with a payments company or a company that is good at raising mortgages – anything like that with which the banks are able to compete with fintech and bigtech better, I think that will be the place where they start. I don’t see them going crazy this time because we have a lot of lessons learnt from recent memory.”

But the divisive Volcker Rule continues to inspire debate. Mary Kopczynski, chief executive and founder of regtech 8of9 and regulatory update platform RegAlytics, questions the timing of the reform.

“These rulings came of course with a boat load of criticism saying it was an inappropriate time to allow banks freedom to blow money in the middle of the pandemic – especially money that had been carved out for safety after the 2008 meltdown,” said Kopczynski in an email.

Bank stocks soared following the announcement, but Kopczynski is wary of long term consequences.

“If you consider the ‘punishment’ of the banks in 2008 as a level 10 punishment and it has been ratcheted down to a level seven, this moves it down to a level five. Is that good in a pandemic? It’s thanks to that ‘punishment’ that we are in a far better economic position than we would have been if a pandemic hit in 2008, but it is also the expense of this pandemic that it might make sense for these banks to be allowed to touch money that is sitting there, available, to try to ensure they make more,” she said.

Mike Minihan, managing partner at BX3, a firm connecting startups with VC funds, also expresses some doubt.

“It is potentially great news for the growth stage venture industry, as well as private equity, and potentially unlocks large amounts of capital. At the same time, it’s a little troubling that banks can take swaths of funds for investment in illiquid assets,” said Minihan in an email.

“In the startup community the reaction is overwhelmingly favourable, but it doesn’t change the way that startups should be evaluated. Essentially, it means there’s a new institutional investor in the market, and the expectations of institutional investors are generally higher around the business fundamentals, including accounting processes, governance, regulatory compliance, etc.”

According to Minihan, illiquid investments with shorter track records will increase risk.

Kopczynski believes the Volcker rollback will be helpful for startups, as it allows banks to invest in private equity firms that in turn invest in later stage companies. Smaller startups will be able to access early capital due to the success of midsize investors.

“Overall, it’s good for startups.  Whether or not it’s good for the safety and soundness of the global banking system is the part that we will get to learn together over the next decade or so,” she said.

With Volcker’s influence weakening, Krishnan wonders what the next era of US fiscal policy will look like.

“The main thing is: Once we come to the other side of the pandemic, how are monetary and fiscal policy going to change to make sure that we put the economy back into the strength it was?”

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