Calibrating the Volcker Rule: Better Get It Right

The Frank-Dodd Wall Street Reform and Consumer Protection Act celebrated its third birthday in July. Yet regulators are just now attempting to hash out the specs of one of the most potent weapons in the new arsenal appropriated to regulators: the Volcker Rule.

Put simply, the Volcker Rule prevents bank deposits that are insured by the FDIC from being used in "proprietary trading," essentially buying and selling securities with depositor's money for profit. The logic behind the rule is as follows: since the deposits are insured by the FDIC, banks have less incentive to invest them carefully, since any losses will be covered by insurance premiums they've already paid. Thus moral hazard induces banks to take more risk onto their balance sheets than they otherwise would ceterus paribus. Heads, the banks win; tails, the FDIC loses.

The treatment for this ailment plaguing the financial system seems straight-forward: ban speculation with depositor's money. As with any complicated medical procedure, however, complications have arisen. Regulators at the SEC and the CFTC are having difficulty formulating a coherent distinction between proprietary trading and its close cousin, "market making." Market making occurs when a bank buys a security with the intention of selling it in the near future and pocketing the spread between the bid and offer. If these two transactions sound eerily similar it's because they are. Market making, however, is done with the intention of being able to offer clients a variety of financial instruments as well as being able to sell instruments on their behalf. In proprietary trading, the bank earns income from solely from successful speculation; market making generates income through commissions paid by clients.

Another banking practice liable to fall as collateral damage should the gauge of the Volcker Rule be set too low is the practice of "hedging". Hedging allows banks to protect the total value of their assets relative to deposit liabilities and hence protect their capital position. Even if a bank were to hold only risk-free Treasury securities, an increase in interest rates would cause a decline in the market value those bonds. Loan default has the same effect. To protect against these types of risks, banks may purchase securities such as forward rate agreements that are expected to reverse correlate with changes in price of the original asset.

Regulators need to properly and clearly define the "Volcker Rule" as expediently as possible, and in doing so take care not to preclude banks from performing functions essential to their stability. Buying and selling securities on behalf of clients is not a clandestine or risky business practice; hedging against risk does not destabilize the financial system.

The fact that the Volcker Rule was included in the Frank-Dodd bill yet is only being defined three years later suggests that regulators expect to wield large discretionary power in deciding what sorts of banking transactions pass muster. This is a mistake.

Financial regulations must be concrete and communicated with clarity, with a minimum of discretion left to the individual regulators. The reason is simple: Regulators at agencies such as the SEC or CFTC or the newly created CFPA are overseen by the House Financial Services Committee and the Senate Banking Committee. These committees are comprised of Congressmen and Senators who rely on the largess of campaign donations to finance their political careers. If broad discretion is left to individual regulators, the whole operation is reduced to something akin to a magic show: impressive sounding regulatory legislation serves as misdirection to distract the public into thinking lawmakers have "reigned in the big banks;" Congress serves as a false wall between the regulators and the firms swapping campaign cash for influence. In the end, no one is held accountable when there's no rabbit in the hat.