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posted: 12/15/2013 6:57 AM

How Volcker Rule would limit banks' risky bets

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  • The Federal Reserve and the Federal Deposit Insurance Corp. each unanimously voted to adopt the so-called Volcker Rule, taking a major step toward preventing extreme risk-taking on Wall Street that helped trigger the 2008 financial crisis. The rule which states that U.S. banks will be barred in most cases from trading for their own profit under a federal rule is named after Paul Volcker, a former Fed chairman who was an adviser to President Barack Obama during the financial crisis.

      The Federal Reserve and the Federal Deposit Insurance Corp. each unanimously voted to adopt the so-called Volcker Rule, taking a major step toward preventing extreme risk-taking on Wall Street that helped trigger the 2008 financial crisis. The rule which states that U.S. banks will be barred in most cases from trading for their own profit under a federal rule is named after Paul Volcker, a former Fed chairman who was an adviser to President Barack Obama during the financial crisis.
    Associated Press

 
Associated Press

WASHINGTON -- U.S. regulators have approved a rule that seeks to defuse the kind of risk-taking on Wall Street that helped trigger the 2008 financial crisis.

The Volcker Rule is expected to change the way the largest U.S. banks do business. It strives to limit banks' riskiest trading bets that could implode at taxpayers' expense. Some think the rule goes too far, others not far enough.

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Here are questions and answers about the Volcker Rule:

Q: What is it?

A: The Volcker Rule is a key plank of a financial regulation law enacted in 2010 to try to reduce the likelihood of another crisis and a resulting government bailout. The rule is intended to bar banks from trading for their own profit. This activity is known as proprietary trading. It's become a huge moneymaking machine for mega Wall Street banks, like Goldman Sachs, JPMorgan Chase and Morgan Stanley. Under the rule, the banks will be required to trade mainly on their clients' behalf.

Still, if it were that simple, the final draft would be a lot shorter than its roughly 920 pages -- about as long as Dostoyevsky's "The Brothers Karamazov." The rule left to regulators the burden of finalizing the fine print.

Besides curbing proprietary trading, the Volcker Rule limits banks' investments in hedge funds and private equity funds, which are high-risk, lightly regulated investment pools.

The rule is named for Paul Volcker, a former Federal Reserve chairman who was an adviser to President Barack Obama during the financial crisis. Volcker urged a ban on high-risk trading by big banks to diminish the likelihood that taxpayers might have to rescue them, as they did after the financial crisis.

Q: Where are the complications?

A: The ban on proprietary trading isn't absolute. There are exemptions. One involves an important activity called market making. When big banks engage in market making, they use their own money to take the opposite side of a customer's trade: They buy or sell an investment to help execute the trade.

Q: Why does the Volcker Rule matter?

Because of the widely agreed-upon need to reduce the dangers that remain in the banking system. Proprietary trading has allowed big banks to tap depositors' money in federally insured bank accounts -- essentially borrowing against that money and using it for investments, such as in mortgage-backed securities. When those bets soured during the crisis -- especially after a wave of mortgage defaults -- the banks were at risk of failing. Most survived only because of taxpayer-funded bailouts.

Q: So would banks be barred from investing the money I deposit?

A: The short answer is no. When people deposit money in a bank, they may expect the bank to use it for conventional safe investments, such as bonds. Those would still be allowed. But banks could no longer borrow against depositors' money to seek outsize returns on complex investments, like derivatives. Derivatives are investments based on the value of an underlying commodity or security, such as oil, mortgages, interest rates or currencies.

Q: How did the rule become so complicated?

A: Regulators found it hard to isolate what precisely distinguishes proprietary trading from, say, market-making. The line can be blurry.

Another challenge: No fewer than five agencies, including the Federal Reserve and the Securities and Exchange Commission, had to grapple with the rule and reach common ground.

If that weren't enough, industry lobbyists used their muscle to try to preserve the banks' trading operations. They won a round in 2011, when regulators approved a draft that exempted "portfolio hedging" from the trading ban. This meant banks could make trades for their own profit to offset the risks of either individual investments or a broader investment portfolio.

Q: What was the banks' argument?

A: They contended that a ban on proprietary trading could bar them from legitimate market-making on behalf of customers and from appropriately limiting their risks by hedging broader portfolios.

Q: But the final rule doesn't include such an exemption for "portfolio hedging." Why not?

A: An event in 2012 may have led regulators to rethink such an exemption. JPMorgan traders in London made huge trades on derivatives with the bank's money -- an ill-conceived bet that cost the bank $6 billion. When the losses came to light, they damaged the bank's reputation. Experts believe the "London Whale" trades, as they became known, helped speed momentum toward a stricter rule. In its latest form, the rule does not exempt portfolio hedging.

Q: So did the banks end up losing on the rule?

A: Their lobbyists are "hugely influential" in crafting regulations, says Cornelius Hurley, a former counsel to the Federal Reserve who heads Boston University's Center for Finance, Law and Policy. "But they don't win every battle."

Q: Will the rule succeed?

A: Hard to know for sure. The final rule requires CEOs of major banks to personally certify once a year that their firms have strong compliance programs. Some big banks have already closed their proprietary trading operations in anticipation of the rule. Still, the rule won't take effect for the biggest banks until mid-2015 and not until 2016 for big banks below the top tier. Its complexity could make enforcement difficult.

"It's all in the details," says James Cox, a Duke University expert on financial regulation. "The longer it gets, the more holes it's got."

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