More questions than answers

THE 37 words inserted into the 848-page Dodd-Frank law overhauling the regulation of America’s financial institutions seemed innocent enough. Lawmakers wanted regulators to come up with strictures that would prevent banks from gambling with deposits insured by the federal government. The resulting rule, named after a prominent proponent, Paul Volcker, a former head of the Federal Reserve, prohibits banks from “proprietary trading”, meaning transactions conducted purely for their own gain, rather than to serve clients. On December 10th five different regulatory agencies approved the Volcker rule; it will come into force, awkwardly enough, on April 1st.

During the three years between its conception and birth, the rule has grown into something much bigger and more complicated than its origins would have suggested. The final version boasts 963 pages, and contains 2,826 footnotes as well as 1,347 questions. (Much of this is a preamble addressing public comments, but that will nonetheless serve as guidance for the rule’s implementation.)

The immediate impact of all this verbiage will be small. America’s biggest banks had already eliminated the most obvious forms of proprietary trading in anticipation of the rule. Their share prices rose slightly after its release, perhaps out of relief that it was not as burdensome as some had expected.

By June large banks must begin reporting some data; full compliance with the rule is not required until July 21st 2015. The rule aims not just to curb risk-taking directly, but to enhance monitoring of it too. Bosses will have to sign statements attesting to the existence of compliance schemes, although not to compliance itself—the kind of carefully constructed arrangement that underscores how very conscious bank executives are of risk, if only on their own account, as it were.

The final rule could have been more onerous than it was. An earlier draft had proposed prohibiting banks from buying securities unless they knew that their clients wanted to buy them. In effect, this would have prevented “market-making”, whereby banks keep a supply of securities on hand, so that they can sell them to a customer on demand, or buy them from one even when they do not have another client lined up to pass them on to.

Without the liquidity banks provide in this way, pension funds and insurers would find it harder, more time-consuming and more expensive to buy and sell bonds and other financial instruments. The rule alleviates this worry somewhat by allowing banks to buy securities to meet “reasonably expected” demand from customers.

In practice banks will probably respond by making markets for a narrow range of securities that already trade frequently, and thus might reasonably be expected to do so in future. Meanwhile, the securities that now change hands less frequently are likely to be shunned, making them even harder to trade. Government bonds are exempted from these rules, so banks may pile into them, although they are currently trading at unusually high prices, and so are far from risk-free.

Another worry relates to the rule’s treatment of hedging. Banks often try to offset some of the risks they incur by, for instance, buying derivatives that would rise in value if defaults on loans or bonds were to increase. The new rule will force banks to tie each hedge to the risks of specific positions they have taken. Yet there are few perfect hedges that zig exactly as the countervailing investment zags. Instead, banks often resort to big “portfolio hedges”, designed to protect against broad risks such as an economic downturn or a rise in interest rates, even though they may not perfectly correlate with its trading posture. Regulators, however, see such hedges as risky proprietary trading in disguise (JPMorgan Chase, an American bank, lost $6 billion on one last year). The Volcker rule bans them.

Where, precisely, the line will be drawn between market-making and proprietary trading, or between legitimate and specious hedging, is anyone’s guess. “A specific trade”, explained Daniel Tarullo, the governor of the Federal Reserve responsible for bank supervision, “may be either permissible or impermissible depending on the context and circumstances within which the trade is made.” This subjectivity hints at the to-ing and fro-ing to come, as regulators and courts gradually clarify the rule with precedents.

Unpleasant surprises may yet emerge. The American Banking Association, a pressure group, worries that the rule unintentionally bars small banks, which are largely exempted from its strictures, from investing in financial instruments that currently form a big part of their capital. Jeb Hensarling, chairman of the relevant committee of the House of Representatives, claims it will increase electricity prices, dent pensions and constrict credit. “We are left with one more incomprehensible Washington regulation”, he said, “that will do nothing to help our nation.”

Daniel Gallagher, a dissenting member of the Securities and Exchange Commission (SEC), one of the five agencies that approved the rule this week, complained that he and his colleagues had been given only five days to review the revised draft of the rule before deciding on it. “All we can say for sure is that the final rule set jettisons scores of flawed assumptions and incorrect conclusions in favour of new, unproven assumptions and conclusions,” he noted dryly, calling its hasty adoption “the height of regulatory hubris”.

The SEC’s rush to vote, Mr Gallagher claimed, was the result of “intense pressure to meet an utterly artificial, wholly political end-of-year deadline.” The administration of Barack Obama has been urging regulators to get a move on, to fulfil its promise to rein in reckless bankers. Whereas prior versions of the rule had been released for comment, the final one was made public only after it had been adopted, despite significant changes.

The SEC also did not conduct a cost-benefit analysis of the rule, as it normally does for new regulations. Officials say the laws from which the rule derives its authority do not require such a study, but there was nothing to stop the agencies involved from requesting one. Their failure to do so deepens suspicions that the rule will cause more trouble than it averts.