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Is the 900-Page Volcker Rule Too Much and Too Late?

Michael Santoli
·Michael Santoli
Is the 900-Page Volcker Rule Too Much and Too Late?

Is the nearly 900-page stack of regulations prohibiting a litany of specific trading actions and dictating how traders are paid the best way to ensure a secure banking system?

This is the guiding hope behind the so-called Volcker rule, a measure meant to ban government-backed banks from speculative trading using their own money. The rule, which has been approved by three of five required government agencies, is a long-in-the-making piece of the Dodd-Frank financial-reform law of 2010, which grew from the 2008 financial crisis.

Named for the former Federal Reserve chairman and Obama administration economic advisor Paul Volcker – who famously said the last useful innovation from the banking industry was the automated teller machine – the rule is aimed at making banking boring again.

Banks are no longer allowed to invest directly in hedge funds or private-equity firms, and all trading by financial institutions will now be restricted to their role as middlemen between clients.

At least, that’s the intent of the Volcker Rule, which in its final form takes a somewhat more stringent stance than the financial industry was hoping when it comes to the gray areas between “proprietary trading” and “market-making” on behalf of clients.

Proprietary trading refers to financial bets that bank traders make in order to profit from market moves – activity that’s unrelated to any client orders.

Banks under the rule must prove that what they claim is market-making” activity for clients is truly that, by showing a demonstrated history of client demand for certain financial products. When acting as market-maker, a bank temporarily buys and sells securities in response to client sell and buy orders, seeking other clients to take the other side of the trade. Bank traders cannot be compensated in a way that would encourage them to seek out trading profits that closely resemble those from outright proprietary bets.

These strictures are targeted at preventing the construction and marketing of custom trading instruments designed to express a particular view on an underlying market, for the benefit of the bank or one particular client at the expense of other customers.

Also prohibited is so-called “portfolio hedging,” in which a bank buys protection against a broad economic outcome while saying it is a hedge against losses in particular loans or securities it owns. This sort of vague insurance policy was what J.P. Morgan Chase Co. (JPM) claimed it had entered in its “London Whale” trade, which cost the bank billions in losses.

Related: Is J.P. Morgan Being Unfairly Targeted for ‘Business as Usual’ in China?

Two areas of the new rule favor banks: The debt of foreign governments can be owned outright, and bank CEOs will not personally sign off on his or her company’s compliance with all elements of the rule.

As I discuss in the attached video with Aaron Task and Henry Blodget, the industry has already gone a long way in this direction. They have, over the past five years, sold or closed hedge-fund and buyout divisions and shut down pure proprietary-trading desks, which sought to profit outright from financial bets using bank capital.

In part, banks have curtailed trading activities in response to stricter capital requirements, which forced them to maintain a much thicker capital buffer against the loans and other risky assets they carry since the crisis.

Some, such as Blodget, argue that simply mandating even-higher capital standards could do the job that the new compendium of regulations seeks to accomplish.

“We have, in effect, a 900-page document that spells out in incredible detail what you can do and what you can’t do,” he says. “We could’ve accomplished the same thing by saying, ‘Banks, instead of borrowing $40 for every dollar you have, you can only borrow for every dollar you have.’”

Instead, we have a typical product of the American legal-legislative-lobbying process, an over-complicated set of provisions meant to codify or ban extremely specific behaviors.

The broad project of making banks more boring – more public financial utilities than aggressive surfers of financial markets – is understandable and largely appropriate. Yet this rule will, almost certainly, result in adverse, unanticipated consequences. If a bank feels it is not sufficiently hedged against an economic downturn, it might lend less aggressively to consumer and corporate borrowers than it otherwise would.

Banks already hold record-low levels of corporate bonds on their books, leaving them ill-prepared to help smooth the debt markets in an eventual selloff in the credit markets. Large mutual fund managers complain that the trading of bonds – which takes place among institutions directly rather than on exchanges – is too unreliable and expensive.

There is a broad risk that the Volcker rule becomes the Wall Street equivalent of baseball’s balk rules – a largely inscrutable and back-fitted set of specific illegal motions that grew out of a very simple principle: “Pitchers shall not deceive the runner.”

In this analogy, the banks are the pitcher looking for an edge. Perhaps after a while, observers will ask:

“Isn’t part of a bank’s job to mediate the flow of capital, anticipate client demands and use reasonable tools to mitigate the risks it’s asked to bear?”

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