Blogs & Comment

The Volcker Rule is more trouble than it’s worth

978 pages of possible loopholes

wall stIt’s been five days since the final draft of the Volcker Rule came out, and the dust is starting to settle. In general, the reception has been much more positive than expected. Canadians, as I wrote last week, are happy with a key exception that will minimize the impact of the new regulations on our banks. South of the border, some prominent sceptics of the Volcker Rule were also happy. “The final rule is 978 pages long, but it’s not a bad effort at achieving that simple result,” writes Matt Levine.

I still don’t think the rule was worth the trouble. The idea behind it, initially circulated in 2009 by former Fed Chairman Paul Volcker, was that banks shouldn’t gamble with their depositors’ money, which is covered by federal deposit insurance. It makes sense for the government to back the banks when they are providing “necessary services,” such as making loans to individuals, government and businesses, the reasoning went. But why should taxpayers be on the hook for speculative bets, known as proprietary trading, that benefit a small group of highly-paid bank employees and the banks’ shareholders? They shouldn’t, Volcker argued. Addressing the issue seemed particularly pressing in the aftermath of the financial crisis, which saw America’s largest investment banks, from JP Morgan to Merril Lynch, acquire a banking licence, which brought with it “the comfort of access to massive Federal Reserve and FDIC (Federal Deposit Insurance Corporation) assistance,” as the former central banker put it. The idea, in other words, sounded commendable and commonsensical.

The problem was translating that idea into regulation. Congress wanted new rules that would ban proprietary trading, but also allow banks to (a) execute trades that would hedge against risk they’d taken on in the course of their more mundane banking business and (b) stock up on financial instruments they think their clients will want to buy and sell — pretty much like a store builds merchandise inventory to be able to get customers what they want fast — an activity known in jargon as “market making.” The chief trouble for regulators was to set out sensible guidelines that would distinguish between the no longer permitted prop trading and the still permissible hedging and marketing making.

The good news is that the five U.S. agencies charged with pulling off this remarkable trick seem to have actually done a rather nice job. Which is why Volcker Rule critics like Matt Levine are pleasantly surprised. This is largely the result of regulators going for a so-called “trust and verify” approach, which Volcker heartily advised them to do after reading the first draft of the rule. Instead of trying to examine every single trade to try to determine whether it constitutes market making, hedging or prop trading, regulators will trust banks to do the right thing — but check on them regularly. It’s the “don’t be dumb” approach, as Levine described it, which should allow banks to operate unecumbered by constant scrutiny.

It might be a smarter way to separate the bankers from the gamblers than what the Europeans are trying. Spearheaded by the U.K., the Old Continent seems inclined to simply build a “ring-fence” between retail banking and investment banking. The idea is that if a bank fails because of investment banking bets gone sour, it can’t use its taxpayer-backed retail deposits to pay off investment banking creditors. The U.S. used to have a similar wall running between commercial and investment banks, instituted by a Depression-era provision known as the Glass-Steagall Act, which was largely repealed in 1999. U.S. authorities, though, were disinclined to re-instate Glass-Steagall after the Great Recession. The Volcker rule, this line of thinking went, seemed like a more nimble regulatory instrument because it would force the bank themselves to spin off their prop trading units — which is what seems to be happening.

Still, the fact remains that the Volcker Rule runs nearly 1,000 pages (and, yes, much of that is a preamble — but this preamble will presumably influence the interpretation of the rule and is therefore an integral part of the rule itself). The length of the rule speaks to the complexity of carrying out Volcker’s initial idea, and it doesn’t bode well for implementation. The general rule on Wall Street seems to be that the more complex regulation is, the more loopholes and opportunities for regulatory arbitrage it will contain. And the likes of Goldman Sachs have already proven apt at exploiting the twists and turns of verbose post financial crisis regulation. By the same token, a highly complex rule is more difficult to police — and U.S. regulators do not exactly have a spotless track-record when it comes to being able to zero-in on brewing trouble.

But if those 978 pages of rules are a pretty good effort to translate Volcker’s idea into actionable regulation, the question arises: Was it really worth the trouble? If separating speculative activity from what commercial banks traditionally do is by necessity very complicated, perhaps it wasn’t the right thing to focus on. Perhaps, as many have argued, concentrating simply on limiting the amount of risky bets banks can take on, as well as ensuring that they understand exactly how much risk they’ve taken on and that they can withstand worst-case-scenario losses, would have been a better way to go. Another, less frequently discussed, fix might have been to simply lower taxpayers’ potential liability by reducing the scope of federal insurance coverage.

We probably got close to the best possible codification of the Volcker Rule we could have hoped for. But as well-written as it might be, the rule still doesn’t seem to pass the cost-benefit test.

Erica Alini is a reporter based in Cambridge, Mass., and a regular contributor to, where she covers the U.S. economy. 

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