Don’t retreat on the Volcker Rule

Federal regulators are expected to give final approval this week to the so-called Volcker Rule, which bars banks from making risky investments with the insured deposits they’re holding for customers. To protect against having to bail out depositors in the event of a giant bank failure, it makes sense to set clear limits on what banks can do with the assets that the federal government guarantees. But the contention surrounding the Volcker Rule illustrates how hard it is for regulators to translate simple concepts into real and effective rules.

The subprime mortgage meltdown and ensuing credit crunch led some to call on Congress to break up the major Wall Street firms and bank holding companies, just as it had done in the wake of the 1929 stock market crash. Instead, lawmakers enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which beefed up regulation of the financial industry without changing its structure. Among other things, the law required banks to keep larger and more readily accessible reserves and to borrow a smaller percentage of the money they loaned or invested. It also included the Volcker Rule to put a virtual firewall between insured deposits and a bank’s Wall Street activities, although it left the details to be worked out by five federal regulatory agencies.

The Volcker Rule was exactly the sort of thing businesses tell Washington they need from regulators: a clear line dividing legal and illegal activity. It told banks that they could not engage in “proprietary trading,” meaning they could buy and sell securities, derivatives or other risky financial instruments only at a client’s request and with the client’s money.

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That simple construct didn’t map well to the complex modern banking industry, however. So Congress and regulators exempted certain proprietary trades, including those that involved little risk (for example, buying and selling government securities) and those done to hedge clients’ bets. And what began as a three-page proposal from former Federal Reserve Chairman Paul Volcker has ballooned to some 70 pages of regulations (not counting hundreds of pages of preamble), reflecting how hard it is to identify an improper “proprietary” trade and a impermissible strategy for hedging. The five agencies are expected to vote on a final version of the rule Tuesday .

Some in the financial industry are still unhappy with the idea of walling off insured deposits from risky trades, which they say wouldn’t prevent a repeat of the subprime fiasco. The ideal safeguard would be to enable struggling banks to fail without dragging down the rest of the economy. But there’s no simple way to do that, which is why Dodd-Frank tries to shore up the system in multiple ways. The Volcker Rule is one of them, the stronger and clearer the better.