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The Globe and Mail

Volcker Rule’s success hinges on regulators

Had you just woken up after a Rip Van Winkle-like siesta of five years, you might not have noticed that the global financial system had been turned upside down. The Dow Jones industrial average is hovering around 16,000 points, close to its all-time high. And the United States is no longer a shareholder of General Motors, having just sold the last shares it inherited through its $50-billion (U.S.) bailout.

But it wouldn't take long to see through the current upbeat mood. The wreckage from the exotic trades that magnified the downturn in the U.S. housing market, and that pushed the financial system to the brink, is still everywhere to be seen. Unemployment remains high and Europe's economy is still reeling.

It is mind-boggling that has taken so long to implement new banking rules to prevent another calamity. Even as five U.S. regulatory agencies have just approved the so-called Volcker Rule, there is no guarantee it will work. It all depends on enforcement by market and banking regulators, a multi-headed beast that could be torn by inconsistent execution.

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The idea that former U.S. Federal Reserve Board chairman Paul Volcker spearheaded four years ago was simple enough: Prevent banks from speculating with federally insured deposits as if they were at a casino. The rule is part of a larger trend: Similarly inspired restrictions have also been brought forward by countries such as the United Kingdom, which is asking its banks to ring-fence their retail operations while keeping their riskier investment activities separate.

In the United States, the Volcker Rule outlaws proprietary trading, wherein banks staffed trading desks with mercenary traders whose only aim was to rake in quick profits using the banks' own money. It will also force banks to part with the hedge funds and private equity funds they sponsored.

The drawn out regulatory debate has centred on hedging and market-making, the grey zones of trading. Hedging transactions, for example, are commonly used by businesses and banks to guard themselves against adverse fluctuations in currencies or commodity prices, so distinguishing a legitimate business trade from a purely speculative one can be tricky. While Mr. Volcker has famously compared so-called prop trades to pornography – "you know it when you see it" – the banking industry was clinging to that confusion in the faint hope of postponing the inevitable.

Two-and-a-half years after the Dodd-Frank law was passed, the Volcker Rule, one of its centrepieces, is finally there. The rules that restrain overly risky trading activities are spelled out in a 71-page text with a 882-page preamble.

Banks are now going through the seven stages of grief over the loss of billions in trading profits. There are those in denial who wish to challenge the rules through the courts. (And there will be no shortage of securities lawyers to take up the case of these deep-pocketed clients.)

Then there are the financial institutions that are caught somewhere between anger and bargaining. Their lawyers are dissecting every sentence in those 953 pages to find loopholes. The documents, from what I have read, are very prescriptive, with a detailed string of exceptions. But as they attempt to cover all forms of risky trading, they may become outdated. Financial markets and technologies change quickly, and bankers will have an even stronger incentive to be creative.

So what hope there is that the new rules will curtail the riskiest trading activities lies on bureaucratic accountability. Banks must set up compliance programs with officers who will verify that trades are made to offset a specific and identified risk, and are not vague bets on the general direction of the economy.

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More importantly, the chief executive officer will have to sign off on that compliance program. No longer will a bank be allowed to plead ignorance as JPMorgan Chase did when it uncovered $6-billion in losses following ill-fated credit default swaps by a small group whose principal trader was largely known outside the bank's walls as the "London Whale."

Lack of oversight would be akin to criminal negligence. Except that contrary to the Sarbanes-Oxley Act by which a CEO and a chief financial officer must certify the accuracy of financial information, there are no million-dollar fines or prison terms for the misleading bankers. There will only be a labyrinth of regulators out to catch the speculators.

How good a bank sheriff will the regulators be? That remains to be seen.

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