Inside Wall Street's Secret Plan to Bore Holes in the Volcker Rule

Last Updated Nov 11, 2010 2:43 PM EST

Big banks sees another route around financial reform, reports the Financial Times:
U.S. financial groups such as Goldman Sachs (GS), JPMorgan Chase (JPM) and Morgan Stanley (MS) intend to take advantage of a little-discussed aspect of the "Volcker rule" â€"- part of the financial reform law approved in July â€"- to continue making direct investments.
Here's how. The Volcker rule, passed under the Dodd-Frank Act this summer, restricts banks from using their own funds to trade short-term securities. But it doesn't limit financial firms from making what are known as "principal investments" in longer-term securities, property and other assets.

What's wrong with that? Principal investments may be just as risky as the kind of proprietary trading the Volcker rule aims to curtail. Before it went bankrupt, Lehman Brothers lost more than $32 billion in prop and principal transactions, including a disastrous 2007 acquisition of a large apartment developer. Economist Simon Johnson tells the FT it would be "pretty crazy" to continue allowing banks to make longer-term bets, adding:

That's exactly how banks blew themselves up.
Very simply, the issue isn't so much whether a bank takes a short-term risk or a long-term one -- it's whether a firm is using its money, as opposed to client funds, to make dangerous bets. It's also a matter of the incentives that banks have to speculate. As we've learned, bank managers and traders took outlandish risks because they stood to make enormous profits, while losses were borne mostly by taxpayers and the broader U.S. economy.

The bottom line is that Wall Street badly wants to preserve its ability speculate with its own assets, regardless of how that's defined. That's why firms are continuing to buy hedge funds, even as the Volcker rule forbids it. It's also why banks are angling to carry on prop trading by creating the illusion that such business is being done behalf of their clients.

None of this is surprising. This is how the financial industry always responds to new regulation. But it does point up the importance of what's currently happening in Washington, as financial regulators follow their mandate under Dodd-Frank to craft rules aimed at making the banking industry safer.

Financial firms, along with their lackeys in Washington, are now pressing officials at the Federal Reserve, U.S. Treasury, SEC and other agencies to dilute these regulations. It's no exaggeration to say that the success of financial reform hinges on how regulators define terms like "proprietary" and "principal."

Which way are they leaning? It's hard to say. That said, it's worrisome to recall that Treasury chief Tim Geithner has expressed skepticism about the Volcker rule. Yet other signs point to financial enforcers taking a tough line with banks. As the WSJ recently reported:

[F]ederal officials have rattled financial-industry lobbyists by saying they intend to hew closely to the 4,631 words about the Volcker rule contained in the new law. One lobbyist says a Treasury official working to craft the provisions told him: "We take a view that the rule is more inclusive." The lobbyist responded: "Are you trying to scare me?"
Let's hope so.

Image from Flickr user Europeanpeoplesparty
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    Alain Sherter covers business and economic affairs for CBSNews.com.