Vexed by the Volcker Rule?

Quick quiz: On which single thing has the Fed spent three years and reams of paper, yet still struggles to define? That’s right! It’s the Volcker Rule—that late addition to 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act! For those keeping score, the rule’s still unwritten as of today. Defining what exactly constitutes “proprietary trading” has proven tough sledding indeed. But it appears the arduous process may finally be drawing to a close: The Fed has all but sworn the rule will be complete next month. Then, we’ll get our first look at how the Fed plans to divide trading and deposit taking. But don’t get too excited: Love or loathe the Volcker Rule, it’s unlikely the rule makes the financial system “safer.” And it’s unlikely it sees a big negative market reception, either.

Volcker Rule proponents believe it creates a safer financial system—a surefire safeguard against another 2008. In restricting banks’ proprietary trading, it aims to prevent banks from “gambling” with depositors’ money, seemingly operating on the premise this risked the financial system in 2008. A fallacy! It wasn’t 2008’s $15.8 billion in realized trading losses or even the $300 billion in loan losses that caused the panic. It was the over $2 trillion in exaggerated and unnecessary writedowns—the unintended result of FAS 157’s (mark-to-market accounting) application to illiquid assets banks never intended to sell, an issue regulators addressed in March 2009. Plus, the Volcker Rule wouldn’t have prevented Lehman or Bear Stearns from going under—they were pure investment banks. AIG, too, wouldn’t have been saved by a ringfence. Nor would Fannie and Freddie. Or WaMu. We could continue, but you get the drift—there was no 2008 proprietary trading crisis. Even more recent trading losses didn’t risk the financial system.

Not that there isn’t a philosophical case for the Volcker Rule—when people deposit money in a bank, they don’t intend their money to be exposed to significant risk. But the notion prop trading is inherently riskier or subject to greater realized losses than plain old lending, as we saw in 2008, is flawed. Loan losses didn’t just dwarf trading losses in absolute terms. Loan losses as a share of banks’ total loan portfolios also exceeded trading losses as a share of banks’ trading accounts. Yet no one’s arguing banks should stop lending in order to protect depositors (and rightly so). In short, those expecting the Volcker Rule to be a fix-all for Wall Street’s ills have probably misplaced their hope—the rule seems like a solution desperately seeking a problem.

Those who don’t like the Volcker Rule typically view it from a different angle: its potential impact on banks’ ability to run a profitable, stable business. In its initial form, the rule seemed a touch heavy handed: It sought to ban all proprietary trading, essentially forcing diversified banks to operate as thrifts. But, as astute observers pointed out, a sweeping ban on proprietary trading would crimp other necessary, useful practices they use to serve customers and manage risk. For example, it threatened to squash market making, which involves firms buying and selling securities to maintain liquidity for clients. It also would have prevented banks from using even simple derivatives trades to hedge risk—something they’ve done for decades. Volcker 1.0 would likely have forced banks to change their business models. But the 1,000 pages written since then reportedly include exemptions for market making, hedging and underwriting—flexibility. So while banks may still need to make some adjustments, it shouldn’t be to the degree first expected—they can still keep key business units and manage risk on their balance sheet as they see fit.

At least, that’s what seems likely based on all the leaks, drafts and public comments of the past three years. It’s entirely possible the final rule ends up tougher than expected—and some officials have warned this could be the case. Even under this scenario, however, Financials shouldn’t face long-term headwinds. Imagine the toughest rule possible—a full firewall between banks’ investment and retail banking operations. It would look an awful lot like Glass-Steagall, and banks did fine during its 66 years in existence. If banks can operate and remain profitable during Glass-Steagall, they can near-certainly adjust to its watered-down cousin, the Volcker Rule.

Whatever the final rule looks like, simply knowing what it is will be an incremental positive. Volcker Rule uncertainty was one of the final pieces of regulatory overhang clouding US financials. Once banks know the rules, uncertainty is likely vastly reduced, and they can start planning and adjusting. Financials firms, overall, likely appreciate the clarity.