Despite a fierce lobbying effort to prevent the new measure, it won out. The Volcker Rule will prohibit banks from trading for their own profit rather than on behalf of customers. We are pleased that the rules came out stronger than anyone expected. Commentators believe that consumers won this round. "Big banks lost," said Mark Williams, a former Fed bank examiner who now teaches at Boston University. "Wall Street aggressively fought the Volcker rule."
The new rule will ban federally insured banks from betting on risky investments such as private equity and hedge funds. Private equity funds buy companies and turn them around before selling them, while hedge funds often employ complex trading strategies. These investments have proved highly profitable in the past, but are also extremely risky because they are often so complicated that most of the world, including experts in this stuff, often don’t understand how these investments work. That is by design.
The Volcker Rule also closes a critical loophole. "The Volcker rule will make it illegal for firms to use government-insured money to make speculative bets that threaten the entire financial system, and demand a new era of accountability from CEOs who must sign off on their firms' practices," President Obama said in a statement. The rule goes into effect in April but banks have until July 2015 to comply.
Also, financial firms may buy and sell securities as a way to hedge bets, but they also take a lot of risks in the process and when they fail, they can bring down others with them. For example, JPMorgan Chase & Co. suffered more than $6 billion in losses from positions by a trader who was known as the "London Whale" for his oversized hedges. JPMorgan Chase is the nation's largest bank and this risky trading has huge repercussions in the financial industry.
Now the Volcker rule will require banks to continually monitor and adjust hedging strategies to ensure they don't become overly risky bets that damage investors.
Another feature of the new rule is that institutions will have to document rationales for hedges. Fed Gov. Daniel Tarullo, who heads the agency's bank supervision and regulation committee, said the "Whale" episode provided "a real-world example of what should not happen in a banking organization."
Banks will be required to keep records to back up their positions, and chief executives will be required to sign off on their firms' compliance. They are also being asked under the new rule to structure employee compensation so that it does not "reward or incentivize" engaging in prohibited proprietary trading practices or expose the bank "to excessive or imprudent risk."
Two Senators who pushed for the rule back in 2010, Jeff Merkley (D-Ore.) and Carl Levin (D-Mich.), said they were pleased that it was tougher than what regulators originally proposed.
Merkley, who is a great consumer and worker champion, joined Levin in a statement on the new regulation, saying the Volcker rule "was intended to change the culture and practices at our nation's largest financial firms, to prevent Wall Street and the big banks from making swing-for-the-fences bets that put depositors and taxpayers at risk. The regulators have taken a serious step forward in mandating critical changes."
This is an important victory for taxpayers and the public and a defeat for Wall Street.
For that we need to thank the heads of the five regulatory agencies who hung tough in the face of strong industry lobbying and opposition, including Comptroller of the Currency Thomas J. Curry, who said at a recent FDIC board meeting, “Issuing a final rule is only the beginning of the process. The OCC will be especially vigilant in developing a robust examination and enforcement program that ensures our largest institutions will remain compliant.” It’s about time.