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The Volcker Rule: How It Will Work, and Why It May Still Fail

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“As a starting point, we think the Proposed Rule is simply too tepid.” That was how Senators Jeff Merkley and Carl Levin opened their February 2012 comment letter to federal banking regulators about the “Volcker rule,” designed to prevent large banks from making risky proprietary trades for their own profit, the kinds of trades that nearly took down the financial system in 2008. The senators, who authored the rule in Congress, were displeased about a number of loopholes added to the proposal, which they said did not “fulfill the law’s promise.” They demanded that regulators “draw brighter lines, remove unnecessary complexities, and enable cost-effective, consistent enforcement.”

Twenty months later, five regulators will today finalize the Volcker rule, and Merkley, for one, is pleased with the result. “I believe the loopholes inherent in that [2012] draft have been significantly reduced or eliminated,” he said in an interview on the eve of the final votes. “I have a much more positive feeling about what will be voted on.” 

The tougher rule is a pleasant surprise, given how reliably Wall Street lobbyists have gutted such efforts in the past. For once, the hard work of members of Congress, advocates, and the public actually produced something that could work. But if you view financial reform like a football game, today’s votes kick off the third quarter of a contest destined for 34 consecutive overtimes. Today’s vote mostly triggers an extended period of data collection and guideline-setting, giving mega-banks many future opportunities to water down the rules. And even if implementation wraps up strongly—as it certainly could—regulatory spine will be needed to prevent another financial crisis. As Merkley noted, in matters like this, “you need eternal vigilance.” And, in Washington and on Wall Street, vigilance has often been anything but.

The Volcker rule, named for former Federal Reserve Chairman Paul Volcker, attempts to modernize the Glass-Steagall firewall between commercial and investment banks for the 21st century. As written by Merkley and Levin, it would stop banks that take customer deposits and borrow cheaply from the Federal Reserve from also running big-bet, high-risk trading operations. The goal is to push that activity out to hedge funds and other private investors, who would pose less of a threat to the financial system. Regular banks would engage in the lending activities critical to a strong economy, rather than gambling with their customers’ money.

In the statute, Merkley and Levin sought to tightly define permitted and prohibited activities. But the three-and-a-half-year rule-writing odyssey enabled banks to spend billions to influence regulators and carve out healthy exemptions for themselves. They were initially successful, but the final language rolls back many of the exemptions. For instance, banks will not be allowed to engage in “portfolio hedging,” trades that offset losses in a broad range of assets. The only allowable hedging must be tied to a specific, identifiable position. Here, the banks were their own worst enemy. JPMorgan Chase’s London Whale trades, the disastrous derivative bets that wound up costing them $6.2 billion, were masked by the bank as a portfolio hedge. The resulting debacle showed that what JPMorgan insisted were trades that hedged risk against “bad outcomes” only introduced a new set of risks, and catastrophic losses. Treasury Secretary Jack Lew, in previewing the Volcker rule, specifically cited the Whale trades as prohibited.

Elsewhere, rule-writers added flexibility. For example, the legislative statute allows banks to engage in “market-making,” facilitating trades for clients in stocks, bonds or other securities. Merkley analogizes this to banks operating like a grocery store, keeping enough bread in stock in case customers request it . “It doesn’t mean you can buy a warehouse full of the bread and bet on the price changing,” Merkley said. Market-making generated $44 billion for the five biggest banks just last year, as they profit from holding the stocks and bonds for a short while. Reformers fear that banks will label virtually every asset they purchase as inventory for market-making, turning it into back-door proprietary trading.

Under the final rule, bank examiners will collect information on market-making, tracking trading inventory (the amount of bread, to use the grocery store analogy), setting limits on individual holdings and determining whether individual cases cross over into proprietary trading. If done properly, it will look a lot like how examiners scrutinize the loan books of smaller community banks. However, the rule may also give banks discretion to decide for themselves whether their trades are permissible.

CEOs will have to certify in writing that their bank has “procedures to establish, maintain, enforce, review, test and modify” compliance with the Volcker rule, and the procedures will have to be approved by senior management and the board of directors. This compliance guarantee was not in the proposed rule, but was sought by Merkley and Levin in their comment letter. A similar certification in the Sarbanes-Oxley financial accounting law, which carries criminal penalties that could have been used during the financial crisis to send non-compliant CEOs to jail, has really never been enforced. Given that history, and the fact that the certification here is even weaker, it’s hard to see it as much more than lip service. Nevertheless, supporters believe that the very act of certification creates a sense of importance around the rule, and will lead banks to pay more attention to their own operations.

The Volcker rule has the potential to really create a firewall between deposit-taking banks and risky trading. Credit should go to Merkley and Levin for doggedly pressuring regulators and fending off attempts to subvert the legislative intent of the rule. Reform-minded regulators like Kara Stein at the Securities and Exchange Commission and Gary Gensler at the Commodity Futures Trading Commission forced the unwieldy collection of regulators writing the rule to take notice and make changes. Former policymakers like Paul Volcker, and activists like Occupy the SEC, which sent a 325-page comment letter on the rule, provided real-world expertise so regulators had another source for technical information besides bank lobbyists. And the public got involved, like the nearly 100,000 people who signed a MoveOn petition to close the portfolio-hedging loophole. “The public may not have been familiar with details, but they understood that banks engaged in an extraordinary gambling operation, where if they won the bets, they’d get private gain, and if they lost bets, there would be public pain,” Merkley said.

But while this inside-outside effort to influence the rule-writing did succeed where so many other Dodd-Frank provisions failed, a long period of implementation lies ahead. “The truth is that this is kind of the end of the beginning,” said Marcus Stanley of Americans for Financial Reform. The regulators must now set out guidelines for market-making, hedging and other bank activities, collecting data and developing more specific parameters for what gets prohibited. And they agreed to delay actual enforcement of the rule until July 2015. This gives banks time to open more loopholes, adjust to the requirements and ready lawsuits. Already, loopholes have been uncovered allowing banks to trade foreign sovereign debt and invest in small hedge funds, which could result in risky trading merely shifting to other areas rather than being stamped out.

Stanley worries that, as the fight shifts to implementation, regulators could shield the data from public view, designating it “confidential supervisory information.” That means we may not really know whether or not the Volcker rule is working. Reasonable disclosure of banking activities, trading inventory and even trader compensation (which should be far less volatile) would increase confidence that regulators are doing their jobs.

Ultimately, strong financial regulations on paper mean nothing if they come into contact with a permissive regulator, unwilling to stop the banks from doing their bidding. These are not laws you can write and walk away from, hoping that the regulators will maintain their commitment to upholding them. “If regulators open up and allow high-risk bets to be made, the law fails,” said Merkley, who after Carl Levin’s retirement next year will be the only author of the rule still in Congress. “Some vigilance is required to remind regulators to fulfill our vision. I’m going to stay connected.”

The ace in the hole for reformers could be the same attention and focus that served them well in the rule-writing process. “If [the regulators] blow implementation and we see another London Whale,” said Marcus Stanley of Americans for Financial Reform, “the momentum for another Glass-Steagall will be much strengthened.” Given the symbolic significance attached to the Volcker rule as one of the only parts of Dodd-Frank meant to actually alter big bank business practices, failure by the regulators to rein in those practices will almost certainly trigger a backlash. It’s somewhat sad that something as obvious as creating a safer banking system must be enforced by constant oversight of those given the task. But if regulators do their job out of fear, at least they’re actually doing their job.

David Dayen is a contributing writer at Salon.