What You Need to Know About the Volcker Rule

This section of the 2010 Dodd-Frank bill was scheduled to go into effect in two weeks.

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The Volcker Rule, part of the 2010 Dodd-Frank bill, was scheduled to go into effect in two weeks’ time. But earlier this year, Federal Reserve Chairman Ben Bernanke conceded that the Fed will miss the upcoming deadline. Even with the deferred implementation, the Volcker Rule is on every banker’s lips. But what is the average person supposed to make of the rule? And how will it impact Main Street, as well as Wall Street?

What is the Volcker Rule?

The concept of the Volcker Rule is to prevent banks from using their clients’ money, which is FDIC-insured, to make potentially risky trades and leave taxpayers to pick up the tab. The Volcker Rule is modeled on the Depression-era Glass-Steagall Act, which prevented a commercial bank (which takes deposits) from doing any trading at all. Volcker is often called Glass-Steagall-lite, because rather than forbidding commercial banks to trade entirely, it allows some trading to occur in those institutions.

Most big banks have both a commercial and an investment side, and the policy will affect all the major financial players, from major banks like Bank of America and JPMorgan Chase to investment firms Goldman Sachs and Morgan Stanley. This is to protect both the bank and its depositors from speculative trading and heavy losses.

The way that the rule is supposed to work is by prohibiting any federally insured depository institution or banking entity, or institution that receives Federal Reserve funds, from engaging in proprietary trading. Very simply put, this means that banks will not be allowed to trade money from their depositors’ accounts for a profit, so that the FDIC, and therefore taxpayers, will not have to cover the bank’s losses.

The loophole

But there’s one problem with the Volcker Rule: While banks can’t trade for profit, they can trade to hedge existing positions. In theory, hedging trades would make the bank no money at all: by definition, a hedge goes up when the original position goes down, and vice versa.

However, big banks’ complex balance sheets defy simple one-to-one comparisons. They have myriad financial instruments on their books, from plain-vanilla mortgages and Treasury bonds to the infamous derivative alphabet soup. Given that complexity, which even experts cannot model perfectly, virtually any trade could be justified as a hedge. Therefore, limiting proprietary trading to only hedges does very little at all.

How can you tell a trade from a hedge? MIT’s Andrew Lo had a simple answer: Just look at how the trader gets paid. A hedge doesn’t increase a bank’s profits; in fact, its impact would likely be hard to quantify. A trader would therefore be paid according to her hedging ability, not the bank’s gain or loss. A speculative trade, on the other hand, is made for profit, and the trader would be paid according to how much she earned the bank. But it’s hard to imagine regulators applying heuristics like this. Instead, they’ll have to take banks’ word for it.

Another snarl in a regulatory tangle

Naturally, banks are not happy with the rule and worried about its implementation. So are many others, from the U.S. Chamber of Commerce to Safeway to Macy’s. Banks no longer follow the 3-6-3 rule: pay 3 percent interest on deposits, charge 6 percent interest on loans, and hit the golf course by 3:00. Instead, they opt for the more lucrative, and riskier, business of investment banking. Whatever the Volcker Rule’s actual effect on proprietary trading, it will most certainly add another layer of regulation.

Government regulators will have to establish a hierarchy of supervisors and a series of checks to be put on banks trading information. This is a nightmare task, because it will require the authors to codify age-old banking questions. What standards will determine whether a hedge is risk-mitigating? How can you quantify what threatens the financial stability of the United States? Which exemptions to the ban on proprietary trading can be justified? Who will oversee these compliance programs, and how? These are just a few of the questions that caused the delayed implementation of the Volcker Rule, and with the widespread impact the provision is bound to have, they should not be taken lightly.

The Volcker Rule seeks to impose an artificial constraint on tightly-knit institutions, separating commercial from investment banking after the fact. The size of both the problem it hopes to tackle and the banks affected stymies the Fed’s implementation efforts. But for all the sound and fury from Democratic lawmakers on one side, and Wall Street on the other, the Volcker Rule might well have little impact on the banking industry.

Anisha Sekar is the vice president of credit and debit products of credit card website NerdWallet.com.