Merriam-Webster’s Dictionary defines “speculation” in 31 words. The key ones are “risk of a large loss.” When Paul Volcker, the former U.S. Federal Reserve chairman, proposed banning speculation by federally insured banks to reduce risk to the world economy, he did it in one paragraph. Four years later, the nation’s regulators issued a final rulebased on Volcker’s proposal. It runs close to 100 pages, with hundreds more in supporting material — and no one is quite sure how it will be enforced. It’s a lesson in how complicated simplifying Wall Street can be.
The idea became law in the Dodd-Frank reforms of 2010. Even as draft rules were being fought over, many banks shut down the desks they used for trades that were solely for their own account, what’s known as proprietary trading. Banks do other kinds of trading that can also make them money, or lose it. One involves the steady stream of securities banks buy, sell and hold so their customers can always buy what they want to buy and sell what they want to sell, an activity called market-making. Another involves trades to offset the risks of a bank’s own transactions, known as hedging. The rule approved Dec. 10 is more lenient on market-making and tougher on hedging than was originally proposed: Regulators grew wary after JPMorgan Chase’s $6.2 billion London Whale loss, which many saw as closer to gambling than to a hedge. Now Wall Street is waiting to see howregulators decide to enforce the rules. The responsibility is split between five agencies with very different agendas. Some care most about keeping markets working smoothly, while others worry most about keeping banks from blowing themselves up.
After the Great Depression, Congress created federal deposit insurance to prevent runs at commercial banks. In return, the banks had to concentrate on making loans while leaving the fancy stuff to investment banks. That dividing line blurred in the ’90s and was erased entirely in 1999 when the Glass-Steagall Act was repealed at the behest of banks like Citigroup that promptly grew big trading operations. The financial crisis of 2008 had its seeds in bad mortgages, but what brought banks to the brink, Volcker noted when he proposed his idea, wasn’t bad loans but the exotic trades they had made around them. The six largest U.S. banks made $15.6 billion in trading profits during 13 of the 18 quarters that spanned mid-2006 to 2010. Theyracked up bigger losses during the five remaining quarters when their bets turned sour. Even after the meltdown and unpopular taxpayer bailouts, taking a step back toward Glass-Steagall met Wall Street resistance. That’s why when President Barack Obama adopted the idea he wrapped it in Volcker’s name, in the hope that the towering stature of the man who tamed 1970s inflation would lend it greater weight.
Many on Wall Street continue to insist that the rule will be unworkable. Distinguishing between different categories of trades and assessing appropriate risks is either impossible or highly subjective, they say. Jamie Dimon, the chief executive officer of JPMorgan Chase, said last year that every trader would need a psychologist and a lawyer by his side to make sure he wasn’t breaking the rule. Volcker responded that the rule could accommodate a range of trading and still stay fairly simple. “It’s like pornography,” Volcker said of prop trades. “You know it when you see it.” Instead of blanket bans, however, regulators sought to define each situation and carve out a string of exemptions, which is how the rule grew and grew. A small but growing number of bipartisan voices in Washington say they may push for a more radical simplification — bringing back Glass-Steagall — if the Volcker rule proves tougher on paper than in practice.
The Reference Shelf
Davis Polk’s Volcker rule website has the final rule text and statements from the various agencies.