The Way to Fix the Volcker Rule
The Trump administration is taking aim at the Volcker Rule, one of the core elements of the Dodd-Frank financial reform, saying it's too complex and burdensome. That's true, but improving the rule shouldn't mean weakening it.
The rule has a vital purpose: denying taxpayer subsidy to speculation. It therefore bans speculative trading at financial institutions with access to federal deposit insurance and emergency loans from the Federal Reserve -- backstops meant to support lending to people and companies, not betting on securities and derivatives.
Trouble is, "speculation" isn't easy to define. At the urging of banks, Congress said the rule wouldn't apply to activities such as market making and hedging, which aren't speculative but which do involve buying and selling securities and derivatives -- the first to meet customer demand, the other to offset the risks of the banks' other holdings.
The need to police this fuzzy boundary has made things very complicated. Positions held for less than 60 days are presumed to be speculative unless banks can show they merit an exemption. This means producing numerous metrics -- on everything from counterparties to inventory aging -- that supposedly reveal traders' intent. Adding to the complexity, five separate agencies oversee compliance; any one financial institution might have to report to them all.
The result is a mess. Granted, the rules have forced banks to improve their risk management and monitoring -- but all the added reporting and compliance hasn't shed much light on what constitutes speculative trading. Many of the metrics aren't useful in themselves, and regulators interpret them in different ways. As former Fed Governor Daniel Tarullo put it, regulators hoped that "it would become easier to use objective data to infer subjective intent. This hasn't happened."
After the Treasury Department issued a critical report, regulators agreed to work on a rewrite and the Office of the Comptroller of the Currency put out a request for suggested revisions. Banks and their lobbyists have sent in proposals that range from mere loosening to outright repeal.
There's a better way. Instead of trying to get into traders' heads, regulators should focus on outcomes. Speculative trading differs from market making, hedging and other permitted activities in that it takes bigger risks, meaning that the returns on the assets in question are more volatile. So set a conservative level of volatility, typically lower than the broader market, beyond which banks would have to explain themselves; if they stay below it -- that is, if they're not generating big gains or losses from price fluctuations -- they'd be presumed to be engaged in permitted activities.
This bright-line approach would save a lot of time and effort -- especially if, as the Treasury has rightly suggested, regulators assign one lead agency to oversee each institution. Many of the most burdensome metrics, as well as the arbitrary 60-day test, could be scrapped. Some speculative trades might slip through (as in the current system), but that wouldn’t matter as long as they didn't put taxpayers at risk.
There's a good case for a more radical simplification of financial regulation -- one that would render the Volcker Rule unnecessary. But that's not yet on the horizon. Under the current approach, the rule is needed. It ought to be fixed, not discarded.
--Editors: Mark Whitehouse, Clive Crook.
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