Cracking the Volcker Rule

Which is worse: translating it or living through it?

It’s no wonder the Volcker Rule has been put on hold. Its principal feature – the ban on proprietary bank trading — is giving the regulators a real headache. The prohibition is supposed to prevent banks from engaging in the kinds of speculative behavior that precipitated the financial crisis. Unfortunately, this purportedly benign project has turned into a diabolical rule-making exercise and has, on top of that, spread new and ominous financial fears throughout the world.

The Volcker Rule was scheduled to go into effect this summer, but the Federal Reserve, Comptroller of the Currency, FDIC, SEC, CFTC and other U.S. agencies involved in its implementation have now conceded that their final regulations — specifying exactly what banks can and cannot do — will not be ready by the July 21st deadline, and no indication has been given as to when the Rule will ultimately go into effect.
The reason for the delay is that the Volcker Rule is a regulatory nightmare. 300-plus pages of proposed regulations, issued last October, have resulted in almost 17,000 comment letters covering more than 1,400 specific provisions of the Rule. In general, the regulations are either so open-ended or so onerous that practitioners could not possibly carry them out with certainty. More than that, the potential consequences of the Rule could be deep, far-reaching and long-standing for both the U.S. and global economies.

“Proprietary trading” under the Volcker Rule is when banks use their own capital to benefit from near-term price movements. Market-making to facilitate customer transactions and hedging transactions to mitigate risk are expressly excluded from the ban. If a bank were to hold a security for fewer than 60 days, however, it would have to demonstrate that the position was acquired in anticipation of customer demand and not for short-term trading purposes. Think of what would go into doing so.

The biggest challenge in the Rule is applying its broad proscription against any activity that “may (i) involve or result in a material conflict of interest between the [bank] and its clients, customers, or counterparties; (ii) result , directly or indirectly, in a material exposure by the [bank] to a high-risk asset or high-risk trading strategy; or (iii) pose a threat to the safety and soundness of the [bank] or the financial stability of the United States.” Good luck, legal & compliance.

Paul Volcker himself has urged regulators to simplify the codification of the Rule and adopt a principles-based approach rather than specific regulations. Other commentators agree that the Rule has created “complexity risk” for the financial system. Critics also believe that preventing U.S. banks from engaging in proprietary trading will reduce their competitiveness, shift trading risk to less-regulated “shadow banks” (such as hedge funds) and ultimately weaken the financial system the ban was intended to protect.

And it doesn’t stop there. Predictions abound in the trade press that the Volcker Rule will dampen liquidity in the global capital markets across all securities and commodities – including U.S. municipal bonds — and raise trading costs and even energy prices (the latter because U.S. banks play such a key role in helping energy companies hedge risk). Since U.S. Treasuries are exempt from the ban, foreign central bankers have complained that their sovereign debt will be put at a competitive disadvantage, and foreign government officials have voiced serious concern about our adopting such a significant financial rearrangement without enlisting international coordination.

Maybe all of these charges are just lobbying fusillades from powerful banking interests defending their lucrative businesses, or maybe they’re just unfortunate short-term effects to which the markets will eventually adjust. On the other hand, what if some of these unintended but adverse and long-term consequences actually do materialize?

Treasury Secretary Timothy Geithner is betting against it, and considers Wall Street critics of the Rule to be “suffering from amnesia about the recent financial crisis.”