On Wednesday, the Federal Reserve and four other regulators unveiled changes to the Volcker Rule, a key component of the 2010 Dodd-Frank financial-regulation law. The New York Times described the change as part of President Trump’s “deregulatory agenda,” but Washington’s rulemaking bureaucracy, now led by Trump appointees, isn’t deregulating—it’s just making a bad rule slightly better, by easing banks’ compliance costs. Government officials, rather than financial executives, remain in charge of determining what’s risky and what’s not, and taxpayers are still on the hook if a big financial firm fails.

The Volcker Rule was a last-minute addition to Dodd-Frank, signed into law eight years ago next month. By January 2010, lawmakers had written much of the bill, which would total 849 pages. President Obama was worried that the law wasn’t strong enough, though, and that it was too complex for the public to grasp. To address these deficiencies, he appeared with Reagan-era Fed chairman Paul Volcker at a White House press conference to announce “a simple and common-sense reform, which we’re calling the ‘Volcker Rule,’ after this tall guy behind me,” as the president said. It sounded simple and reasonable enough: “banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers,” Obama declared.

Yet it took five federal regulatory bodies, including the Fed, four and a half years and 272 pages to formulate this “simple” rule. The problem was the definition of “proprietary trading.” Investment banks engaged in two types of trading activities before the financial crisis: buying and selling securities for their own short-term profit, which the Volcker Rule would prohibit; and buying and selling securities in anticipation of demand from customers, which the rule would allow. But these activities are often hard to distinguish. When a bank keeps tens of millions of dollars of corporate bonds on its books, it expects the price of those bonds to go up. The price will go up, if other investors—including bank customers—want to buy the bonds. In this case and others, serving customers is indistinguishable from earning a short-term profit. The rule assesses not outcomes, but traders’ intentions. The 272 pages mention the word “intent” 41 times without explaining how regulators would discern it.

Banks responded by paring back their inventories of bonds and other securities for sale, making for less liquid markets. Some financial experts warned that the rule could make a future financial crisis worse: when asset values are falling in such a climate, it’s good to have big investors at hand, including banks, to buy those assets if they think that prices have corrected too far. But unless a bank could identify a future buyer for such assets—unlikely, during a crisis—such purchases would constitute prohibited speculation. As Jack Bao and Xing Zho, of the Federal Reserve Board, and Maureen O’Hara, of Cornell, wrote in 2016, the Volcker Rule has increased “the illiquidity of stressed bonds”—that is, bonds that investors believe might default. “Dealers regulated by the rule have decreased their market-making activities,” they observe, not stepping in to buy when others are selling, and vice versa. The authors found that investors not regulated by the rule didn’t step in to replace the banks as big buyers. “The net effect is that bonds are less liquid during times of stress due to the Volcker Rule,” they concluded.

The most serious problem with the Volcker Rule, though, isn’t its complexity or even its deleterious market effects—it’s with the reasoning that Obama offered for the rule. “These firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people” (italics mine). But banks are not supposed to be backed by the American people. Yes, small depositors who maintain checking or savings accounts at FDIC-covered banks, whether at a small local branch or at Goldman Sachs, enjoy protection from bank failure. The FDIC, a government-chartered insurer, covers their comparatively modest losses. But the rest of the bank is supposed to go bankrupt, with larger depositors, bondholders, and shareholders all facing risk of loss.

The philosophy of the Volcker Rule, then, is contrary to free-market values. Sophisticated investors in banks, whether bondholders or shareholders, should determine whether an institution’s trading activities are too risky. If they cannot do so because of the opacity of a multi-trillion-dollar financial entity, they should refrain from investing in such entities. The rule also runs contrary to good regulatory values. Regulators shouldn’t tell banks which assets or investment vehicles they can and can’t invest in. Rather, they should subject all activities to basic limits on borrowing as a percentage of assets and impose basic transparency rules governing trade pricing. Investing in a staid, well-diversified private-equity fund—prohibited under the Volcker Rule—may be safer than investing in a portfolio of high-risk real-estate loans, which the rule permits.

It’s a bad sign that the proposed amendments to the Volcker Rule clock in at 373 pages—longer than the rule itself. And the aim of all these pages isn’t to change the rule, but to change compliance with it. Specifically, regulators, after nearly eight years of struggling over how to discern “intent,” will now simply listen to what the banks say they intend to do with their securities, as reflected in how the banks treat such securities in their accounting practices. But accounting practices are not an objective science, so the problem of assessing intent remains. The other key part of the proposed amendment, directing regulators to focus on firms that do the most trading, seems sensible—if the goal is to make it cheaper and easier for firms to comply with a “too big to fail” regime.

Indeed, in announcing their revision of the rule, regulatory officials reiterated their support for too big to fail. In voicing support for the changes, Fed governor Lael Brainard, an Obama appointee, reminded her colleagues that “banks should not engage in speculative trading . . . for which the federal safety net was never intended.” It’s telling that Volcker himself isn’t troubled by these proposals. “I welcome the effort to simplify compliance,” he said on Wednesday. “What is critical is that simplification not undermine the core principle at stake—that taxpayer-supported banking groups . . . not participate in proprietary trading. . . . I trust that the final rule will strongly maintain that position.” When it comes to financial regulation, if you’re talking about “federal safety nets” and “taxpayer-supported banking groups,” you’re doing it wrong.

Photo by Spencer Platt/Getty Images


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