Risky trading to be curbed

The Volcker rule - named after former Federal Reserve Chairman Paul Volcker - is a key plank of the Dodd-Frank financial regulation law that was passed in 2010 in response to the global financial crisis of 2008. It was approved after two years of debate and lobbying by the big banks to modify it.

"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," US President Barack Obama said after the rule was approved by five US regulatory agencies, including the Federal Reserve and the Securities and Exchange Commission (SEC) on Tuesday (10.12.2013).

In essence, the rule severely limits so-called proprietary - or prop - trading, where banks trade for their own profit. US banks are required to put in place compliance programs and document trades to demonstrate that they are in a client's interest or a hedge against risk, rather than purely for profit.

Profound or inept?

"There hasn't been a change this big in the banking industry since 1933," says Mark Williams, a former Fed bank examiner who now teaches at Boston University and has written extensively on the collapse of Lehman Brothers.

"The onus has been pushed back on banks to demonstrate that they are not in violation…through good record-keeping, analysis, through back-testing. They have to demonstrate that they are using risk-management best practices in their hedging operations."

But critics say it is unworkable, as it will be hard to distinguish between mere gambling and legitimate trades.

"It won't work because it will be too easy to evade," Bill Black, also a former regulator, who now teaches at the University of Missouri-Kansas City, told DW.

Apart from being far too much work for understaffed regulatory agencies, he says, "as soon as you tell the banks they can hedge, against a trillion and a half dollars worth of their portfolio, tell me you couldn't find something that that would be a hedge for."

"It's a tragic lost opportunity for real reform," Black told DW. "It is worse than nothing," he says.

Back to banking basics?

Many experts consider proprietary trading to be one of the reasons for the 2008 crisis, in particular the rise of a specific type of prop trading, so-called mortgage-backed securities, "manufactured by some of the largest banks…, sold by them and kept in their portfolios," Williams told DW. These securities often involved repackaged subprime mortgages that led to mass foreclosures, when people could not pay their loans off.

Working in banking now is a far cry from the 1980s when "being a banker used to be a "respected, but also a very boring profession," Williams says.

"The traditional banking model was a two-legged stool - banks earned income through loans and through fee services, like asset management."

To make more money "the very large banks brought a third leg to that stool and that was prop trading…and that leg is being knocked out and it's going to be a tough transitional period for many of these large banks."

And, indeed, the American Bankers' Association (ABA) argues in a statement on their website that, apart from being "burdensome and highly complex," the rule will lead to "decreased liquidity and inferior product pricing" for customers.

The banks were hoping that the Volcker rule would be much less stringent, but a 6.2-billion dollar trading loss by JPMorgan Chase in the UK in 2012 - known as the "London Whale" - gave the Volcker implementation process the "momentum," Williams says, to curb proprietary trading in a more substantial way.

JPMorgan Chase, he says, "was a hedge fund disguised as an FDIC- [federally - the ed.] insured commercial bank."

"There's going to be much less profit to be made from that third leg," he says, arguing that the London Whale loss, and more importantly, the fact that the trader hid the true extent of the losses from management, could have been prevented had the Volcker rule been in place.

Still too big to fail

Bill Black is among those who are calling for much tougher measures, such as cutting banks down to size to eliminate the "too big to fail" argument that he believes encourages risky behavior.

Because of the feared domino effect of one of the big banks failing and dragging the whole economy down with it, "too big to fail institutions - the systemically dangerous institutions - can borrow much more cheaply, which creates a huge competitive advantage," he told DW.

Borrowing, especially short-term borrowing, grew rapidly in the run-up to the 2008 crisis, says Benn Steil, senior fellow at the Council on Foreign Relations in a memorandum. So, an approach to reform "that restricts the scope and incentives for bank balance-sheet expansion funded by short-term debt is essential to prevent another crisis." The Volcker rule will do nothing of the sort, he argues.

Glass-Steagall to the rescue?

Black goes a step further by insisting that the Glass-Steagall Act from 1932/33 should be reinstated. It was part of the US Banking Act passed in the wake of the Great Depression. It separated traditional banking from riskier activities like investment banking. It was repealed in 1999, allowing practices like proprietary trading to emerge.

"It [Glass-Steagall] worked brilliantly for 50 years and was praised by almost everybody," Black told DW. But "we violated one of the key rules of life - if it's not broke, don't fix it," he said.

Black says it is not just the US that has so far failed to pass meaningful regulation. "Contrast the boldness of the US response to the Great Depression and the successful boldness in regulation with the timidity of the global response to the current crisis, where we feel that we can't even think boldly."

The Volcker rule will come into effect on April 1, 2014, but banks have been given until mid-2015 to fully comply.