More than three years since enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, U.S. regulators took a significant step forward in the implementation of meaningful financial reform yesterday, as five agencies — the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, and the Securities and Exchange Commission — all voted to adopt the final version of the Volcker Rule. The final rule is much stronger than the first draft in two key ways: it offers clearer and stricter definitions of what activities are not allowed at certain banks and it puts rules in place that can help change some of the riskier elements that have become a part of banking culture.
The Volcker Rule, which was initially proposed by former Federal Reserve Chairman Paul Volcker, seeks to stop federally insured banks from making high-risk speculative bets, known as proprietary trading, with their assets. The rule had three primary goals: 1. separate core banking services — taking deposits and making loans — from high-risk trading; 2. eliminate egregious conflicts of interest in bank trading activities; and 3. address similarly risky activities at “too big to fail” institutions.
In short, the rule’s objective is to ensure that large financial firms are in the business of providing lending and other services to clients — businesses and families — while leaving high-risk investing to hedge funds and other private investors where major losses won’t imperil the lending that the economy needs.
The draft regulation, released in 2011, came under criticism from both consumer advocates and industry as being both too vague and overly complex. But the rule approved yesterday is both stronger and simpler than the 2011 draft. Most significantly, the final rule closes a loophole that would have enabled banks to make big bets in their portfolios — referred to as portfolio hedging — in effect, limiting their hedging activities to those that act as a counter investment specifically designed to reduce the bank’s risk. The Volcker Rule as passed by Congress permitted only hedges tied to specific investments, but the initial draft rule loosely interpreted this trading ban and would have allowed the same type of portfolio hedging that led to the notorious “London Whale” trade that cost JP Morgan billions.The rule also simplifies provisions for banks to help connect buyers and sellers — also called market-making services — clarifying that banks can help meet real customer demand without taking risky speculative bets.
Furthermore, the final rule takes important steps aimed at changing the culture at our nation’s “too big to fail” firms by placing limits on trader compensation structures and increasing CEO accountability. First, it tightens requirements regarding trader compensation to prohibit banks from inappropriately incentivizing risky behavior. Second, the rule requires CEOs to certify that their firms have appropriate systems in place to ensure Volcker compliance — although it does stop short from requiring CEOs to certify they are actually in compliance with the Rule.
As with any regulation, implementation of the rule will be key to its success or failure. With five regulators charged with overseeing components of the rule, there needs to be systemic real-time data sharing across agencies. Enforcement needs to be coordinated, consistent, and strong, and the regulators must be adequately resourced.
The rule also needs to be implemented expeditiously. Banks will begin reporting the data needed to implement the rule starting in July 2014, and full enforcement will come into effect the following year. The regulators, who are already behind schedule, must be vigilant to curtail unnecessary delays.
In the coming days, policymakers, lawyers, and bankers alike will be pouring over the rule to gain a better understanding of its complexities. We are unlikely to grasp the full impact of the rule for several years. But without question, yesterday’s landmark ruling is an important beginning. If well-enforced, the final rule provides the framework to ensure we have proper limits in place to better safeguard our financial system.