American Banker recently leaked details on the Volcker rule proposal to restrict the activities of financial firms that the FDIC will vote on later this week, and it set off a whirlwind of speculation about what the proposal would mean for financial markets.
What is the Volcker Rule?
The Volcker rule prevents firms from engaging in what is known as proprietary trading. Proprietary trading occurs when a financial firm uses the funds in its equity accounts, i.e. its own money, to try and profit by trading in stock, bond, or other financial markets. The problem is that if these trades get the firm into trouble, and if the firm is too big to fail, i.e. if it is backed by an implicit or explicit government guarantee, then the firm is likely to take on too much risk. The reason is that if the firm makes risky bets and wins, it profits handsomely and executives are amply rewarded. However, if it makes bad bets and the firm gets into trouble, the government will step in and shore up the losses. Thus, since losses are likely to be covered to a significant extent, there is less reason to worry about taking on excessive risk and they are more likely to get into trouble that requires a government bailout and taxpayer losses. The Volcker rule attempts to prevent firms from engaging in this type of behavior.
Is the Volcker Rule Needed?
There is a debate over the extent to which removing Glass-Steagall -- the old version of the Volcker rule -- contributed to the crisis. However, whether the elimination of the Glass-Steagall act caused the present crisis is the wrong question to ask. To determine the value of reinstating a similar rule, the question is whether the elimination of the Glass-Steagall act made the system more vulnerable to crashes. When the question is phrased in this way, it's clear that it has made the system more vulnerable for the reasons outlined above.
Is the Rule Strict Enough?
Given that a Volcker rule is needed, as I believe it is, is the proposed rule strict enough? Unfortunately, it's difficult to tell since the proposal is incomplete or vague in many places. Many of the details are left to be completed in coming months, and the proposal also poses scores of questions that must be answered before the rule is finalized (the FDIC vote later this week puts the legislation into a comment period that ends in December). For example, the proposal takes no stance on whether the CEOs of financial companies must attest that to the company's compliance with the rules and simply asks whether this should be part of the final legislation.
However, for the most part the proposal is being described as a victory for banks. One reason is the the large number of issues that are left unresolved. That's an indication of disagreement on a number of points, and lobbyists will have time to exploit and widen those differences as they attempt to keep particular pieces out of the final legislation.
Another reason this is being described as a win for banks is the vagueness of the proposal. As the NY Times notes, "The Volcker Rule exists in a gray area, where the line is often blurred between when a trade is proprietary or part of a bank's routine market-making activity, which can include buying securities with an eye toward later selling them to clients." This makes it difficult to write specific rules -- a difficulty that extends to other areas of the legislation -- and much is left to the discretion of regulators. It will be up to individual regulators to "know it when they see it," and the degree to which regulators do or do not enforce tough rules will be a key to the legislation's success. Given that regulators did not enforce rules strictly before the crisis, and given the political power of large financial institutions, there is reason to be wary about how tough regulators will be. It's not just willingness to be tough. Though that is part of it, it's also the ability to make correct calls when the lines aren't very clear, and when regulators have much less experience than market participants in the areas they are trying to regulate.
A third reason this is being described as a win for banks is that there was also some question about the degree to which banks would be allowed to engage in underwriting, hedging, and market making. But "The draft proposal that emerged on Wednesday would exempt even more varieties of hedging than originally expected." This was favored by banks, but it creates the potential for "more aggressive trading tactics" and that's not good news for the stability of the financial system.
[Update: See here for another perspective.]