The Volcker Rule’s Definition Problem

Implementation of Congress’ attempt to regulate banks’ proprietary trading was delayed Friday to give regulators time to define what they’re regulating.

Do you have to define something in order to regulate it?

In an announcement Friday, the Fed answered in the affirmative as it pertains to US bank holding companies’ compliance with the Dodd-Frank Act’s Volcker Rule. The rule was originally slated to take effect July 21, 2012. Now banks will have until at least July 21, 2014 to comply. Considering as of now banks have been given very little actionable sense of what’s permissible and what isn’t under the Volcker Rule, this seems like a sensible delay indeed.

As a refresher, the Volcker Rule (named for former Fed Chairman Paul Volcker) seeks to limit banks’ proprietary trading, which some regulators have deemed too risky. (Though there’s scant evidence this proprietary trading was a key driving factor behind 2008’s financial crisis.) But regulation limiting proprietary trading likely wouldn’t be the most disastrous thing ever, if it were well crafted.

And therein lies the principal problem. In all its 298 glorious pages (more than eight times as long as 1933’s Glass-Steagall Act, the Volcker Rule’s far stricter loose model), the Volcker Rule fails to draw a bright line between proprietary trading and market making. Lawmakers do not wish to target the latter—banks nearly constantly standing ready to buy or sell securities in order to maintain liquidity for their clientele. But the difference between the two is often subjective at best, considering securities bought by a market maker may not be immediately saleable. A strictly implemented Volcker Rule prohibiting bank purchases of securities for their own accounts could seemingly infringe on market making, widely considered a highly innocuous—if not beneficial—practice.

But the Volcker Rule’s problems aren’t limited to this. Consider: Embedded in the draft were over 1,300 questions, or about four per page. Many remain open. When the draft was released for comment, a deluge of more than 17,000 letters arrived—from banks, financial companies, foreign governments and many others. Some banks have even taken steps to change their registration structure, renouncing their standing as bank holding companies to avoid being subject to the ambiguous rule. Even Paul Volcker himself criticized the draft, telling a New York Times reporter late last year:

“I don’t like it, but there it is,” Mr. Volcker told me in his first public comments on the sprawling proposal.

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

The lack of clarity surrounding the Volcker Rule seems to be more an example how Dodd-Frank’s financial reforms have been crafted than an exception. Many draft rules are over a year overdue today. Studies remain incomplete. And the definition problem seems a big part of these broader issues as well. Terms like “speculation” and “derivatives” exist throughout the law, but they’re defined so vaguely farmers and small businesses ... “Main Street” ... would likely bear significant pain from a law supposedly targeting “Wall Street.”

That banks won’t have to attempt to comply this summer with a rule that seems fuzzy at best is a plus, in our view. Ultimately, sensible regulation is best fostered through clear, concise rule writing. Banking is a complicated enough business without having an ambiguous Volcker Rule governing it. Hopefully, regulators can use the next two years either greatly revising (or deleting) this rule, so poorly defined its own namesake doesn’t much like it.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.