01/12/2012 02:17 am ET Updated Mar 13, 2012

Volcker Rule Worries Japan Over Impact On Its Government Bonds

* Japan worried rule could raise costs of trading JGBs

* Also concerned about more U.S. control over Japan banks

* Also concerned about inclusion of short-term FX swaps

By Rie Ishiguro and Kaori Kaneko

TOKYO, Jan 12 (Reuters) - The Bank of Japan and the nation's banking regulator have told the U.S government they are worried that the controversial Volcker rule could hurt trading in Japanese government bonds.

The so-called Volcker rule, which would limit banks' trading with their own funds, could make JGB trading less attractive and profitable, said a letter addressed to U.S. monetary and financial authorities.

"Some of the Japanese banks might be forced to cease or dramatically reduce their US operations and Japanese subsidiaries of US banks may consider exiting from JGB trading," it said.

In the letter, dated Dec. 28 but only made public on Thursday, the BOJ and the Financial Services Agency then called on Washington to expand the range of exempted securities substantially to include JGBs.

A trader at a Japanese bank said that domestic banks may need to scale back some of their operations in New York but that so far there had been no price movements in the JGB market to suggest that it was worried about a large impact on liquidity.

The Volcker rule aims to restrict banks from engaging in speculative investments that do not benefit their customers, and will apply to foreign banks' U.S. subsidiaries as well as to domestic institutions.

However there is growing concern by foreign governments that the new rule and other parts of the Dodd Frank financial oversight law will give American regulators increasing jurisdiction over non-U.S. banks.

In the letter, the Japanese authorities also stressed that they were opposed to American regulators exercising more control over their banks.

"Considering the potentially serious negative impact on the Japanese markets and associated significant rise in the cost of related transactions for Japanese banks, we would appreciate your refraining from extraterritorial application of the restrictions," they said.

Japan is not the only country to have raised concerns about the Volcker rule's impact on non-U.S. banks. Canada has also complained that the rules would limit its banks' ability to effectively manage their liquidity.

Japanese authorities also expressed their concern that short-term foreign exchange swaps would also be subject to the restrictions, saying that they are often used for the purpose of US dollar funding by major foreign banking entities rather than as tools for proprietary trading.

The restrictions "could squeeze USD funding significantly outside the US and could accelerate the deleveraging of European banks by liquidating foreign assets," it said.

The rule was originally proposed by American economist and former Federal Reserve Chairman Paul Volcker.