Federal regulators moved Tuesday morning to approve a final draft of a long-awaited provision of the Dodd-Frank financial reform law that would limit banks from making speculative bets for their own profit and from running hedge funds.
Dubbed the "Volcker Rule" after former Federal Reserve chairman and prominent financial reform advocate Paul Volcker, the measure has been at the rule-writing stage for three years, after being included in the 2010 Dodd-Frank law. Tuesday's vote marks a major step in what has been a long and drawn-out struggle between the rule's proponents and bank lobbyists who have tried to shape the final result.
The version of the rules released Tuesday include some measures that bank critics had pushed for since the original proposal was released in October 2011.
The rules bar banks from engaging in speculative trading for their own books, a practice called "proprietary trading." It also defines exemptions from the ban to allow banks to fulfill traditional banking services. Among the allowed activities is market-making — holding positions on both sides of a trade to facilitate customers' trading in that asset. They also include hedging, that is, buying or selling a security or derivative to mitigate risk.
The rules approved Tuesday by the Federal Reserve and Federal Deposit Insurance Corporation tighten those exemptions by requiring banks to demonstrate that any market-making activities be designed to meet, not exceed consumer demand. They also would have to document a specific rationale for any hedging trade. These measures are intended to ensure that banks are not indirectly engaging in trades for profit, as opposed to for client services.
The rules also would aim to prevent traders from being paid based on profits they generate, in an effort to eliminate incentives for bank employees to make risky bets on the bank's behalf.
Dennis Kelleher, the president of the financial reform group Better Markets, called the final rules "a major defeat for Wall Street and a direct attack on the high-risk ‘quick-buck’ culture of Wall Street."
Critics argue that the kinds of proprietary trading curbed by the Volcker Rule were not the root cause of the financial crisis. Douglas Holtz-Eakin of the conservative American Action Forum wrote in an email Tuesday morning that "at best, the rule will be complex, micromanaging and expensive."
The rule-writing process took a turn toward more aggressive oversight partly because of JPMorgan's 2012 "London Whale" trading scandal in which the bank's London risk management office lost more than $6 billion in trades of the kind the Volcker Rule is intended to prohibit. Regulators, including Treasury Secretary Jacob Lew and Fed governor Daniel Tarullo, have said that the new rule would prevent further events like the London Whale.
And although Republicans have generally been skeptical of the rule, the Democratic Party has moved toward a more stringent approach to bank regulation. In part, that shift has been driven by the 2012 election of the former Harvard Law professor and prominent Wall Street critic Elizabeth Warren to the Senate. The Massachusetts senator, who says she's a supporter of the Dodd-Frank law, has urged federal agencies to finish writing tough laws and said that Congress should act legislatively to address the problem of banks that are too big to fail without public assistance if regulators do not.
Sixty percent of the deadlines for writing rules have been missed, according to the law firm Davis Polk & Wardwell, which tracks the law. Only 165 of the total 398 total required rule makings have been finalized.
In addition to the Fed and FDIC, three other agencies were scheduled to vote on the rules Tuesday: The Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Office of the Comptroller of the Currency. The rules would take effect in April and banks would be required to conform by July 2015.
Over the past three years, many banks have already shut down their in-house proprietary trading units or moved traders into other roles in anticipation of the Volcker Rule taking effect. That could be a sign that the rule is acting as planned to prevent risky behavior by banks, or it could simply mean that banks have moved those activities outside of the scope of regulators' oversight. Fed officials emphasized at Tuesday morning's meeting that implementing the rule would require ongoing vigilance.