Volcker Rule Gets It (Mostly) Right

The immediate goal of the Volcker rule, which U.S. regulators approved after a troubled four-year gestation, is to end speculative trading by banks. It also has a larger ambition -- to tame the culture of excessive risk-taking that had Wall Street in its grip by 2008.

How does the final product measure up to those aims? It will displease bankers because it’s tougher than they expected. It will disappoint many of the banks’ critics, who had hoped for fuller retribution for years of bank-induced economic misery. It finds a middle ground, and it gets the main things about right.

The 71-page Volcker rule won’t stop banks from trading on their own accounts altogether (that would take an army of mind-reading supervisors); nor will it reinstate Glass-Steagall, the law that separated commercial from investment banking (which would take an act of Congress). Instead, the rule attempts to curb risk in the part of the financial system that is taxpayer-protected -- and to nudge banks back to making money as advisers and middlemen. That line of business was never wildly profitable, which helps explain why the Volcker rule was so strenuously opposed.

The final rule is strongly written, but traders will doubtless find ways around it. Perhaps that’s why the stocks of the banks with the biggest trading operations, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., rose after the rule’s approval.

The final rule tries to close loopholes in the hedging and market-making exemptions that banks might exploit, but in the end it relies, as it has to, on senior managers to push cultural change down from the top. Directors and top management, it says, “are responsible for setting and communicating an appropriate culture of compliance.” In addition, chief executive officers must annually attest in writing that their banks have “procedures to establish, maintain, enforce, review, test and modify” their compliance programs. Notice, however, that the rule doesn’t require bank executives to personally guarantee that their institutions are actually in compliance.

The rule is shot through with similar “do the right thing” diktats that boil down to judgment calls. The words “reasonable” and “substantial” appear often. For example, to receive an exemption to conduct market-making, trading desks must both buy and sell contracts or enter into both long and short positions of the instruments they trade for their own accounts. The trades, however, can’t exceed the “reasonably expected near-term demands of clients.”

Some parts lack clarity and may need further refining. To receive an exemption for trades meant as hedges, banks must demonstrate that they are reducing “specific, identifiable” risks, but it isn’t clear by how much.

Nor is it clear what regulators mean when they say banks can hedge an “aggregate” position. This would seem to allow hedges for entire portfolios of, say, corporate loans, though certainly not the way JPMorgan conducted its “London Whale” portfolio hedges. Those positions, which were supposed to protect the bank against a deterioration in corporate credit, instead morphed into a huge bet that caused the bank to lose $6.2 billion.

Regulators relaxed other parts of their 2011 proposal. Buying and selling the securities of foreign governments won’t be considered proprietary trading after all -- largely a response to criticism from European officials who said that such a prohibition would harm their sovereign debt markets.

Regulators also allowed overseas banks more flexibility. They won’t have to comply with the prop-trading ban so long as those doing the buying and selling are physically outside the U.S.’s borders.

Beyond prop trading, the Volcker rule limits bank investments in private equity, hedge funds and commodity pools. Here, regulators granted broad exemptions for some types of activities, including joint ventures, the issuance of asset-backed securities and wholly owned subsidiaries. Regulators may need to revisit these exemptions later.

What if the unexpected happens, as it’s bound to? They thought of that. The rule prohibits anything that would “substantially increase the likelihood that the banking entity would incur a substantial financial loss or would pose a threat” to financial stability. That’s good. Regulators need to hedge sometimes, too.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.