On Tuesday, five federal agencies approved a key financial reform intended to keep banks from making risky bets for their own profit. Known as the Volcker rule, the regulation took three years to finalize and withstood a concentrated lobbying front from Wall Street and business groups.
As recently as last month financial reformers expressed concern that the final rule would leave critical loopholes open and fail to stop banks from engaging in speculative trading, with taxpayers vulnerable to big losses. But after seventy-one pages of official guidelines were unveiled yesterday, reform advocates appear to have won their campaign for a stronger law. But because of critical gray areas in the rule, how much stability it restores to the financial system depends on implementation and enforcement. (For a deeper dive into the specifics of the final rule, read Alexis Goldstein on wins, losses, and toss-ups.)
“Today’s finalization of the Volcker Rule ban on proprietary trading is a major defeat for Wall Street and a direct attack on the high-risk ‘quick-buck’ culture of Wall Street,” said Dennis Kelleher, the president of the advocacy group Better Markets, in a statement. “Regulators have resisted much of the heavy Wall Street pressure to weaken an earlier proposal. In fact, they seem to have strengthened the rule in several significant ways,” wrote Americans for Financial Reform, another advocacy coalition.
The ultimate goal of the Volcker rule is to make banking boring again by rebuilding a wall between commercial banking activity and the kind of risky trading done by investment firms. The rule bans commercial banks from making bets for their own profit rather than for their customers, a practice known as “proprietary trading.” Banks suffered about $230 billion in proprietary trading losses during the first year of the financial crisis, and taxpayers were on the hook for the massive bailouts required to keep the banks afloat. More recently, proprietary trading disguised as risk hedging caused JP Morgan’s “London Whale” scandal, a loss of $6.2 billion in 2012.
Whether the Volcker rule will truly stop proprietary trading depends in large part how strictly regulators enforce it. Under the rule, banks will establish their own compliance programs, and officials from several agencies will be responsible for policing their activity. There’s plenty of gray areas in the rules, and supervisors from agencies with different perspectives will have to decide when banks are engaged in allowed activities, like risk-hedging and market making, and when they’re cheating.
“Given the absence of a lot of ‘bright-line’ distinctions, I think supervisors are going to bear going forward an important responsibility to make sure that this rule really works as intended,” said Janet Yellen, vice chair of the Federal Reserve board of governors and Obama’s nominee to head the agency. The board voted unanimously to approve the final rule, with several other board members noting that the real strength of the rule depends on implementation.