Both Wall Street and Washington, poring though the Volcker rule’s almost 1,000 pages of legal-speak on terms like market-making and portfolio hedging, can find reasons to claim victory.
For regulators, adoption of the final rule puts a capstone on a five-year effort to impose new order on the banking industry after its risky mortgage securities took the financial system to the brink in 2008. The rule, which bans banks from making speculative bets for their own accounts, “will change behavior and practices in our financial markets to safeguard taxpayers,” Treasury Secretary Jacob J. Lew said.
For Wall Street, much of the rule is open to interpretation -- wiggle room that should give banks ample opportunity to keep profiting, albeit while spending more on compliance lawyers. Another win: banks don’t have to fully comply with the rule until July 2015.
“Of course they are going to find loopholes. They’ve got a year and half before this thing is even implemented,” Commodity Futures Trading Commission member Bart Chilton said in an interview with Bloomberg Television. “They are going to be looking at these gray areas with a fine-toothed comb.”
Chilton said the rule, which gained final approval by five U.S. agencies today, was “rigorous and strong” and designed to prevent another trading debacle like the $6.2 billion loss by JPMorgan Chase & Co.’s London Whale last year. Only weeks earlier, Chilton had vowed to vote no if he deemed it too easy on banks.
Most of the large firms affected by the rule, including JPMorgan and Goldman Sachs Group Inc., have already shut their proprietary trading desks. The rule’s nitty-gritty details will be worked out largely in private in negotiations between banks and their supervisors over which trades remain permitted.
“As they await future regulatory guidance, many bankers will struggle to understand complex provisions that have no application to their business model and are open to conflicting interpretations, particularly given the number of regulatory agencies involved,” said Frank Keating, president of the American Bankers Association.
Wall Street foes warned that allowing negotiations to take place behind closed doors could allow banks to evade the rule.
“The Volcker rule cannot be allowed to disappear into a private conversation between Wall Street and its supervisors,” said Marcus Stanley, policy director of Americans for Financial Reform, an umbrella organization for groups that favor tough regulation. “Regulators must provide the public with transparency regarding the application of the rule.”
When the Obama administration began pushing its plan for a financial regulation overhaul in 2009, the Volcker rule wasn’t a part of the legislative package. It was first introduced in January 2010 after Democrats lost the Massachusetts Senate seat long held by Ted Kennedy in an election seen as a referendum on President Barack Obama’s healthcare proposal.
Seeking to change the subject and tap into populist anger over the $700 billion bank bailout, Obama brought former Federal Reserve chairman Paul Volcker to the White House to outline the idea that would later bear his name. The concept initially wasn’t even backed by leaders of the president’s economic team.
Referring to “this tall guy behind me,” Obama lashed out at Wall Street: “We have come through a terrible crisis. The American people have paid a very high price. We simply cannot return to business as usual.”
By the time the Dodd-Frank Act was enacted in 2010, the Volcker rule was touted as a centerpiece.
In the three years since, regulators have struggled to translate Volcker’s plan, which also included restrictions on investing in hedge and private equity funds, into formal rules.
The confusion was aided by a Wall Street-led lobbying campaign joined by business groups including the U.S. Chamber of Commerce and dozens of financial firms like Vanguard Group Inc. Hedging, the industry told regulators, was vital to managing the risks of their business. And they said market-making -- the practice of holding an inventory of securities to ease trades for clients -- was important for keeping costs down for investors.
The government, the campaign emphasized, shouldn’t be deciding how to trade securities, a situation that had a real potential to roil markets.
A first draft was issued in 2011 and it became clear that Wall Street had succeeded in muddying the waters. The proposal ran 298 pages and contained some 1,300 questions.
To combat the industry’s assault, regulators decided to strengthen the tone of the final rule even as they revised some of the fine print on hedging and market-making to accommodate business concerns.
One new provision calls for CEOs to certify that they have set up compliance programs for monitoring the Volcker restrictions. The measure doesn’t require executives to swear to the firm’s actual compliance -- a relief for the banks.
Another section of the final rule mandates that traders can’t be paid in a way that rewards them for making risky proprietary trades.
Initial analyses of the hedging and market-making restrictions conclude that Wall Street can live with the rule. While the hedging provision was tightened from the earlier proposal, it still allows banks to broadly hedge some of their risks.
Seeking to prevent another London Whale, regulators said banks must analyze and independently test that a hedge “demonstrably reduces or otherwise significantly mitigates one or more specific, identifiable risks.” Banks also must provide “ongoing recalibration of the hedging activity” to ensure it is allowed.
On market-making, regulators gave Wall Street some leeway, reducing the list of criteria banks must meet to have their trades classified as permissible. The trades must not exceed, on an ongoing basis, the “reasonably expected near-term demands of clients.”
Washington research firm Capital Alpha Partners LLC called the market-making requirement “manageable” in a note it sent to clients.
“Despite a huge new reporting regime of quantitative measures, market making can generally continue,” the firm wrote. “The final rule allows for more profit to derive from inventory.”
Much remains to be seen about the rule, even whether it takes effect. Industry groups, which have not been shy about suing over other Dodd-Frank rules, say that the Volcker requirement, because of its complexity, could be another target.
Even if there is no court challenge, regulators said that the rule will be a work in progress as banks and the agencies that supervise them work to translate some of its nebulous details.
“The ultimate effectiveness of the rule will depend importantly on supervisors, who will need to find the appropriate balance,” Chairman Ben S. Bernanke said.