“The phrase ‘too big to fail’ has entered into our everyday vocabulary,” wrote then-Chair of the President’s Economic Recovery Advisory Board and former Chair of the Federal Reserve Paul Volcker in a 2010 op-ed for the New York Times. “It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks.”
Volcker, who chaired the Fed for nearly 10 years (August 1979 to August 1987) under Presidents Jimmy Carter and Ronald Regan, has earned a place in history as a brilliant economist and Wall Street watchdog. As Chair of the Fed, he is perhaps best remembered for curbing the rampant inflation, and as Chair of President Barack Obama’s Economic Recovery Advisory Board, he is perhaps best remembered for the provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that bears his name, the Volcker Rule.
The Volcker Rule — which pretty much tacked hastily on to the end of the Dodd-Frank Act in January 2010, after the law had already passed the House of Representatives — is designed to limit the degree to which large financial institutions “can count on public support at critical times.”
The rule prohibits depository banks — those protected by the Federal Deposit Insurance Corporation — from risky proprietary trading, investing Tier 1 capital in private equity or hedge funds, or to abuse derivatives for hedging purposes aimed only at increasing profit, and not done in the interest of customers. The Volcker Rule is similar to the Glass-Steagal Act in that it seeks to regulate how commercial banks handle risk, and to ensure that any losses incurred from proprietary trading do not ultimately fall on the shoulders of the taxpayer.
The Glass-Steagal Act was effectively repealed in 1999 with the passage of the Gramm-Leach-Bliley Act, which removed the barriers between banks and securities and insurance companies that were established by Glass-Steagal. Many observers of the late-2000s financial crisis have cited this development as a major reason why the financial system destabilized. The Gramm-Leach-Bliley Act was one of the things that allowed financial institutions to become too big to fail by conflating the roles of commercial banks, securities firms, and insurance agencies, and allowing them some degree of protection under the government (taxpayer) umbrella.
“As things stand,” Volcker explained in 2010, “the consequence [of too big to fail] will be to enhance incentives to risk-taking and leverage, with the implication of an even more fragile financial system. We need to find more effective fail-safe arrangements.” Ostensibly, one of those arrangements is the Volcker Rule.
The problem, though, is that everybody seems to have a broad understanding of what the Volcker Rule should do, but there is no agreement on how it should work. The language of the rule was meant to be finished more than a year ago, but still the five agencies involved in drafting the legislation — the Fed, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the FDIC, and the Office of the Comptroller of the Currency — have yet to agree on the details.
The Financial Times reported on Sunday that the Fed, which has served as the primary shepherd of the Volcker Rule, is considering delaying compliance of the yet-to-be-finalized provision for another year, until July 2014. Barring more delays, the final draft of the rule is not expected until sometime in December, which would give banks just six months to comply.
The primary hangup in drafting the legislation appears to be this: how tight to make the controls? If the regulation is too strict, financial institutions could find them burdened with a competitive handicap, and unable to effectively service the needs of their clients. Too loose, and what’s the point? For the record, the version of the Volcker Rule in question is not a straight ban on propriety trading. The proposition as tacked on to Dodd Frank would allow banks to use up to 3 percent of Tier 1 capital to invest in private equity or hedge funds.
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