Five Years After the Sub-Prime Crisis, Regulators Face Critical Moment in Implementing the “Volcker Rule”

Almost four years since President Obama endorsed the so-called “Volcker Rule,” five US regulatory agencies are still debating its precise formulation. The rule, which is designed to prohibit banks from making risky, speculative bets, was passed into law as Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) on July 5, 2010. Since its proposal by former Federal Reserve Chairman Paul Volcker, it has been the most hotly contested provision of Dodd Frank, and its implementation will be seen as an indicator of the strength and effectiveness of the legislation as a whole. Further, as the signature element of President Obama’s financial reforms, the vigor with which the Volcker Rule is formulated will inevitably come to be seen as emblematic of the administration’s relationship with Wall Street.

Background: From Glass-Steagall to Dodd-Frank

Major reforms of the US financial system have largely tracked to catastrophic market failures and the public outcry they precipitate. The stock market crash of 1929 resulted in the collapse of 11,000 banks over a four-year period, and, among other things, triggered the longest recession in United States history. In response to this crisis, the United States Congress passed the Glass-Steagall Act, a staggeringly simple piece of legislation (37 pages as opposed to the 298 page Volcker Rule) that forced the separation between investment and commercial banking. The logic of this regime was simple: The commercial banking sector, which performs the necessary activity of taking deposits and providing credit, should not be dragged down by the more casino-like activities of these institutions. As a result of this forced bifurcation, many banks chose to spin off their investment banking and securities businesses into separate firms (this gave rise to, among others, Morgan Stanley).

After nearly seven decades of financial stability, and at the height of “Go-Go ‘90s” hubris, Congress repealed Glass-Steagall in 1999. Designed to maintain the global competitiveness of American financial firms, the Gramm-Leach Bliley Act allowed commercial and investment banking to take place side-by-side. The forced separation of commercial and investment banking prevented firms from cushioning their riskier activities with the reliable cash-flow of deposits and lending, which had the dual effect of limiting the size of market participants as well as the size of the bets they could make. Gramm-Leach Bliley removed this restriction and, after nearly a decade of mergers, gave rise to the massive conglomerates that were the epicenter of the 2007 financial crisis.

The Volcker Rule Explained

The Volcker Rule has the same regulatory objective as Glass-Steagall but operationalizes it in a different manner. Glass Steagall approached the problem structurally, by forcing banks to spin off their riskier activities into separate companies. However, the Obama administration deemed the investment and commercial banking activities of modern US financial institutions to be too complexly intertwined to be unwound. The administration, on the advice of Paul Volcker, instead opted to prohibit commercial banks from engaging in proprietary trading via the Volcker Rule and the enforce stricter capital requirements (the amount of money kept on hand by banks) by adopting the Basel III international banking framework. Proprietary trading encompasses trades in a variety of financial instruments with the firm’s own money so as to make a profit for itself. Under the Volcker Rule, banks are prohibited from making such trades and from owning or investing in hedge or private equity funds, though they can still make trades on behalf of their customers and engage in “hedging activities in connection with…individual or aggregated positions…that are designed to reduce the specific risks to the banking entity.” Commercial bank deposits are insured through the Federal Deposit Insurance Corporation and these institutions have access to cheap credit through the Federal Reserve to cover short-term liquidity shortages. These protections were designed in the wake of the 1929 crash to instill public confidence in banks, and, regulators argued, should not be available to institutions engaged in risky bets. Therefore, the Volcker Rule (as part of a larger regulatory apparatus) was designed to prevent banks from taking excessive risks because of their implicit state backing (the “moral hazard” problem).

As stated above, there is an exception to the general prohibition on proprietary trading for hedging activities relating to individual or aggregated positions. This exception has proven to be a controversial one. In May 2012, JP Morgan Chase, the largest bank in the United States, announced a USD 2 billion loss on a massive trade placed out of its London office. This trade of credit default swaps (one of the now-infamous instruments of the 2007 crisis), known as the “London Whale” by traders at the firm, would not be prohibited by the Volcker Rule as it hedged an “aggregated position.” Herein lies the problem—a bank the size of JP Morgan Chase is so interwoven into the fabric of the world economy that almost any trade could be considered a hedge of an aggregated position.

Regulators Seek a Delicate Balance

The above loophole is only one of the many problems facing the implementation of the Volcker Rule. Though passed into law in 2010, it was left to regulators to craft definitions that would distinguish between permissible and impermissible trades and strike a balance between a globally competitive financial industry and a stable one. Federal regulators—including the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, and (my personal favourite) the Office of the Comptroller of the Currency—all have a hand in drafting the regulation and were due to complete it a year ago. Treasury Secretary Jacon Lew has strongly urged federal agencies to complete the regulation by the end of the calendar year, and President Obama has recently stressed the importance of meeting this deadline. Moreover, firms have until 2014 to comply with the rule.

Peter Eavis and Ben Protess of the New York Times have reported on the divisions between different regulators and the daily 1000-page drafts circulated by the various participants. Some agencies want a strict formulation of the rule, while others have advocated its dilution. The way the finalized rule is formulated will have long-lasting consequences for the US financial system and, as 2007 proved, the world economy as a whole.