U.S. banks pushed regulators to widen proposed restrictions ontrading and hedge-fund ownership by foreign firms, then encouragedgovernments around the world to complain about the rule'sreach.

The two-pronged lobbying strategy resulted in foreign officialsjoining U.S. lenders to push back against the Volcker rule, namedafter former Federal Reserve Chairman Paul A. Volcker andincorporated in the 2010 Dodd-Frank Act.

“The criticism of foreign governments on behalf of their banksis helping U.S. banks fight the rule,” said Anat Admati, aprofessor of finance at Stanford University. “It also muddies thewater, shifting the debate away from the main issue, which isreducing the risks banks impose on the economy.”

The Volcker rule seeks to prevent deposit-taking firms frommaking bets with their own capital or owning hedge funds. Lastyear, U.S. banks including JPMorgan Chase & Co. and MorganStanley lobbied the Fed and other regulators to apply theregulation more broadly to companies based outside the U.S.,according to four people with knowledge of the discussions whoasked not to be identified because the talks were private.

In a December 2010 phone call, a lobbyist for JPMorgan told Fedofficials the Volcker rule would create “a competitivedisadvantage” for U.S. banks, according to a document posted on theagency's website. Seven Morgan Stanley executives met with six Fedstaff members last April to express similar concerns, anotherdocument said.

Banks and their lobbyists later sent position papers to theWashington embassies of foreign governments and met with officialsto warn that sovereign-debt prices would suffer if U.S. banks arebarred under the Volcker rule from buying other nations' bonds fortheir trading accounts, three of the people said. That led to anoutpouring of letters from Canadian, Japanese and European Unionofficials, as well as from dozens of non-U.S. lenders, urgingregulators to overhaul the rule.

“The global reaction has been extraordinary,” said Karen Petrou,managing partner at Federal Financial Analytics, a Washington-basedresearch firm. “If regulators don't feel like they have enoughflexibility to satisfy foreign governments' demands, they could goback to Congress, which would open the whole rule torevisions.”

298-Page Proposal

In recent months, as regulators sought comments on a 298-pageproposal to implement the Volcker rule, the outcry from banks hasswelled. Lobbyists have argued that the plan would reduce tradingin bond markets and increase borrowing costs for investors andcompanies. One industry-funded study said the additional expensejust for the corporate bond market could be as much as $360billion.

Complaints from foreign nations and banks center on language inDodd-Frank exempting U.S. Treasuries from the ban on proprietarytrading because they're deemed safe, as well as on the rule'sattempt to control activities outside the U.S.

The exemption for Treasuries didn't arouse much opposition untiltwo months ago, after U.S. banks began calling representatives offoreign governments in Washington, warning that sovereign-debtprices would suffer if they weren't allowed to buy the bonds fortheir trading accounts, say lobbyists and regulators familiar withthe talks.

Banks based outside the U.S. met with their home-countryregulators and central bankers, briefing them about the dangers andunfairness of the proposed rules, the people say. Allen & OveryLLP, a law firm representing a dozen non-U.S. lenders, includingFrankfurt-based Deutsche Bank AG and HSBC Holdings Plc in London,said its lawyers, accompanied by bank executives, held meetingswith the U.K. Treasury, the European Central Bank, Canada's financeministry and German regulators.

The Volcker rule's extraterritorial reach didn't become clearuntil after the Fed, the Federal Deposit Insurance Corp., theOffice of the Comptroller of the Currency and the Securities andExchange Commission published a draft proposal on Oct. 11. Whilethe Dodd-Frank Act said that U.S. divisions of foreign banks wouldhave to abide by the restrictions, the plan extended that to coverthe activities of any bank with a connection to the U.S., even asingle branch in one state, according to lawyers and bankexecutives.

“If you look at the proposed rule's preamble, it's clear thatthe U.S. regulators are trying to level the playing field betweentheir banks and the outsiders,” said Douglas Landy, the NewYork-based head of the U.S. financial-services regulatory practiceat Allen & Overy.

Merkley, Levin

Even U.S. Senators Jeff Merkley of Oregon and Carl Levin ofMichigan, who pushed Dodd-Frank's Volcker rule provision throughCongress, said in a Feb. 13 letter to regulators that the proposalgoes beyond the bill's original intent by seeking to preventnon-U.S. banks from owning stakes in private-equity or hedge fundsoffered to U.S. citizens.

U.S. banks and their lobbying groups held 21 meetings with Fedstaff from September 2010 to October 2011 to discuss the Volckerrule, according to the central bank's website.

The banks started calling on foreign governments and regulatorsafter the draft proposal was released in October, with effortsintensifying in December. That culminated in a flurry of publicstatements in January and February from high-ranking officials,including Bank of Canada Governor Mark Carney and EU FinancialServices Commissioner Michel Barnier.

U.K. and Japanese finance ministers also weighed in today,saying that without an exemption from the rule, their governments'borrowing costs would rise.

“At such a vulnerable time in the sovereign debt markets, itwould be the wrong prescription,” U.K.'s George Osborne and Japan'sJun Uzumi wrote in a Financial Times opinion article.

The response from foreign governments and banks “shows theveracity” of the argument U.S. banks have been making since theVolcker rule was proposed in 2009, said Randy Snook, executive vicepresident of the Securities Industry & Financial MarketsAssociation, which represents the largest U.S. lenders.

“Banks serve a crucial role in government bond markets, and theregulation would restrict that,” Snook, who's based in New York,said in an interview. “It doesn't respect the market-making role,either, and would hurt these markets seriously.”

Snook declined to say whether banks had lobbied regulators toextend the Volcker rule's reach. Spokesmen for Morgan Stanley andJPMorgan, both based in New York, as well as for the Fed, the FDIC,the OCC and the SEC declined to comment.

The agencies, which are sifting through more than 300 commentson the proposal, face a July 20 deadline when the Volcker rule isscheduled to go into effect.

The rule, designed to keep banks from taking excessive risks,attempts to prevent them from using their own money to makeshort-term bets while allowing them to buy and hold securitiestemporarily in anticipation of future customer demand for thetrade.

Market-Making

Foreign banks, like their U.S. rivals, will have to prove thattheir buying and selling amounts to market-making for clients, notproprietary trading. They also can't own more than a 3 percentstake in any hedge funds or private-equity funds that do businesswith U.S. residents, which would rule out most such investments,bankers and lobbyists say.

The proposed restriction would, for example, prevent a foreignbank's London-based trading desk from using the firm's capital tobet on any security traded on a U.S. exchange, according to theInstitute of International Bankers, a New York-based lobbying groupfor overseas lenders with U.S. operations.

That London unit also can't make any bets involving investorswho are U.S. residents, and the bank's U.S.-based brokers can'ttake part in transactions, even if both the buyer and the sellerare outside the U.S., the IIB wrote in a Feb. 13 letter toregulators.

“The proposed version basically exports the Volcker rule to ourbanks' home-country operations,” said Richard Coffman, IIB'sgeneral counsel. “The only way they could avoid the rule's reach isby de-banking from the U.S.”

Senators Merkley and Levin backed restrictions on proprietarytrading of sovereign bonds other than U.S. Treasuries in theirletter to regulators. They said dabbling in such debt couldincrease risk for U.S. banks. Greece, whose debt was ratedinvestment grade as recently as 2010, is in the process of swappingsovereign bonds held by banks and hedge funds for new ones worthabout 70 percent less as the EU tries to avert a default whichcould result in even greater losses.

In their letter, the senators explained that Treasuries wereexempted because they're safe, don't pose a foreign-exchange riskfor U.S. banks holding them and are used for liquidity managementby the country's lenders. That isn't the case for other sovereignbonds, the senators said.

Sovereign Debt

“For the EU to be treated as safe as U.S. Treasuries islaughable when they're restructuring one of their member's debt,”said Simon Johnson, an economics professor at the MassachusettsInstitute of Technology. “The lesson we've learned from the EUcrisis is that a bank should only consider as safe the debt backedby its own central bank.”

Volcker has said that barring U.S. banks from trading othercountries' bonds won't hurt liquidity in the market for thosesecurities. The largest banks in Europe, Japan and Canada should beable to pick up the slack, Volcker, 84, wrote in the FinancialTimes on Feb. 14.

Stanford's Admati said she doubts restrictions on tradingsovereign bonds will raise borrowing costs in any significant way.A study by Thomas Philippon, a professor of finance at New YorkUniversity, showed that increasing liquidity in financial marketsover the past 140 years has made it costlier for companies toborrow or raise capital. More trading activity results in atransfer of economic resources to the financial industry, Philipponwrote in the November paper.

Even if borrowing costs rise when liquidity drops, complaintsfrom foreign governments are akin to asking for a subsidy, Admatisaid.

“Why should the U.S. taxpayer subsidize other governments'borrowing costs?” Admati said. “When banks insist they must be theones providing market-making, they in effect want the U.S.government to subsidize this activity through its safety net. Thiscan reduce the borrowing costs of governments only if you don'tconsider the cost to U.S. taxpayers of the safety net.”

Admati made a similar argument in response to complaints frombanks as far away as Singapore that they will have to abide by theVolcker rule in their global operations even though they have onlya tiny U.S. presence — a single branch that helps corporate clientswith trade finance. Those banks can receive support from the Fedduring a financial crisis, she said.

'90-Degree Tilt'

One example: Norinchukin Bank, which pools the resources ofJapanese agricultural and fishing cooperatives. It has only onebranch office in the U.S. and should be exempt from the Volckerrule, the Tokyo-based lender wrote in a Jan. 25 letter toregulators. Norinchukin borrowed as much as $22 billion ofemergency funds from the Fed during the financial crisis, accordingto data released by the central bank and compiled by BloombergNews.

While applying the Volcker rule to foreign banks may help levelthe playing field for U.S. firms, it won't go far enough inalleviating the burden imposed by new regulations, said MargaretTahyar, a New York-based partner at Davis Polk & Wardwell LLPwho represents some of the largest U.S. banks.

“The Volcker rule was already a 90-degree tilt against U.S.banks in the Dodd-Frank Act, hurting their competitivenessinternationally,” Tahyar said. “Regulators have used somediscretion to lower that disadvantage, but it's now a 70-degreetilt — still pretty steep.”

The international outcry, while it may help U.S. banks maketheir case for revising the Volcker rule, won't undermine its basicpremise, said Kim Olson, a principal at Deloitte & Touche LLPin New York and a former bank supervisor. A similar global campaignagainst capital rules proposed by the Basel Committee on BankingSupervision in 2010 didn't deter regulators from going ahead, shesaid.

“The big question is whether the merits of the outcry are solidenough to sway the views of the regulators,” Olson said.

MIT's Johnson said the lobbying strategy could backfire.

“It's a miscalculation by the banks,” Johnson said. “Thelobbyists have backed the regulators into a corner. They can't givein when all these foreign governments are pressing them. It wouldlook bad before elections to cave in to foreign demands when yourpublic wants you to be tough on banks.”

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