The Volcker Rule Is Tough. It's Complicated. Will It Be Effective?

The Volcker Rule bars banks from gambling with deposits
Paul Volcker, former chairman of the U.S. Federal Reserve, in 2012 Photograph by Peter Foley/Bloomberg

In 2009 former Federal Reserve Chairman Paul Volcker had a simple idea to prohibit deposit-taking banks from trading for their own accounts. Proprietary trading—wherein banks make bets in pursuit of profit, putting depositors and taxpayers at risk—shouldn’t be that hard to define, he told the Independent, a British newspaper, last year. “It’s like pornography,” he said. “You know it when you see it.”

Defining the sin of proprietary trading wasn’t as easy as the wise man believed. Regulators’ first crack at a Volcker Rule drew more than 18,000 comments. Wrangling went on for a year and half past the summer 2012 scheduled date for completion. Five agencies finally adopted the rule on Dec. 10. Including a preamble, it comes to 964 pages. The only people who seem truly happy with the final product are lawyers: Jones Day alone had 200 attorneys around the world reviewing the rule the week it came out. Compliance is expected to take 2.3 million hours of paperwork annually, according to government estimates.

Is the Volcker Rule worth all the trouble? Scheduled to take effect in July 2015, it will make banks safer by prohibiting some risky trading practices. The big banks have seen the writing on the wall and already shut down their proprietary trading desks. And they’re selling their hedge funds and private equity businesses, which the rule also prohibits. “A lot of the change is already taken out of the system,” Bank of America Chief Executive Officer Brian Moynihan told a Goldman Sachs conference on Dec. 10. Richard Kovacevich, former CEO of Wells Fargo, says the Volcker Rule “appears to be reasonable and one the industry can live with.”

At the same time, the rule will complicate banks’ ability to perform some of their routine functions, such as buying and selling stocks and bonds on clients’ behalf. More important, it does nothing about the biggest risks facing the banking system. “It sucked up the oxygen and energy that could have gone into much bigger problems,” says Anil Kashyap, a professor of economics and finance at the University of Chicago Booth School of Business. Kashyap cites rules for lightly regulated money-market mutual funds (“still a menace”), liquidity requirements to keep banks from running out of cash in a crisis, and procedures for handling failures of banks that do business internationally.

Any hope the banks had that regulators would go easy on them disappeared after JPMorgan Chase’s disastrous London Whale trade, which CEO Jamie Dimon initially dismissed as a “tempest in a teapot.” That trade, which cost the bank more than $6.2 billion, was originally described as a “hedge”—a transaction designed to counterbalance other parts of the bank’s portfolio and thus reduce overall risk. In the rule released on Dec. 10, regulators ordered more reporting and clear descriptions of trades to stop London Whale-style freewheeling. Banks can’t point at a pile of securities they’ve bought and call it, vaguely, a “portfolio hedge.”

Under the Volcker Rule, banks that help companies issue stocks and bonds can still hold some of those securities temporarily as part of the underwriting process. Banks are also allowed to make markets—that is, stand ready to buy when their clients are selling, and sell when they’re buying. A bank can quietly accumulate shares in, say, IBM to meet “the reasonably expected near-term demands of clients.” Critics argue the rule will still crimp market-making. René Stulz, a professor of banking and monetary economics at Ohio State University’s Fisher College of Business, says a reduction in the number of deep-pocketed players willing to buy and sell in financial markets “could ultimately make the banks riskier rather than safer.”

No one can say for sure how the rule will work, because even in 964 pages it doesn’t spell out unambiguously what’s allowed. Janet Yellen, who has been nominated to become the next chairman of the Federal Reserve, said as she voted to approve the rule: “Supervisors are going to bear a very important responsibility to make sure the rule really works as intended.”

Since five agencies are in charge of compliance, multiple regulators could target the same activity in a single firm in different ways, says Julie Williams, who was chief counsel for the Office of the Comptroller of the Currency before joining consulting firm Promontory Financial Group. Banks may shy away from permissible activities just to avoid getting too close to the blurry line, says Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics, a consulting firm that has big banks as clients. “It would be better to have a few bright lines” separating permitted from prohibited activities, she says.

Even Wall Street critics worry about vagueness. Americans for Financial Reform, which expressed satisfaction that “regulators have resisted much of the heavy Wall Street pressure to weaken an earlier proposal,” warned that bank supervisors now have “a great deal of discretion in determining just what kinds of trading will be permitted.” But Volcker himself, in an interview, says the rule does “a good job of balancing” specific rules and general principles.

Some still argue that Congress should go back to a version of the Depression-era Glass-Steagall Act, which barred deposit-taking banks from investment banking activities. Senators Sherrod Brown, an Ohio Democrat, and David Vitter, a Louisiana Republican, favor a different approach: requiring the biggest banks to have a thicker safety cushion of capital, which would give them a financial incentive to shrink. “It is premature for anyone to take a victory lap when ‘too-big-to-fail’ policies are still alive and well,” Brown said in a statement last week. “Despite what some on Wall Street and in Washington may say, our work is not finished.”

— With assistance by Dakin Campbell, Jesse Hamilton, and Yalman Onaran


    The bottom line: Even at 964 pages, including a preamble, the newly approved Volcker Rule leaves many questions unanswered.

    Before it's here, it's on the Bloomberg Terminal.