Toward a Better Volcker Rule

It is inevitable that there will be another financial crisis, and policymakers today must work to make the financial system more robust to shocks, whatever the source. Following the recent crisis and the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), regulators have increased capital requirements, proposed rules to improve liquidity management, and developed procedures to resolve large institutions without bailouts and market disruption. While limits on proprietary trading were not included in the original financial reform proposals from the Treasury Department, the Obama administration eventually supported them in the form of the Volcker Rule and the Lincoln Amendment. The rationale for these provisions is that banks should not use their position as holders of FDIC-insured deposits or their ability to borrow at the Federal Reserve’s discount window to generate funds for certain types of speculation. The Volcker Rule and the Lincoln Amendment were controversial at the time of enactment and remain so today. In the end, however, the Volcker Rule and the Lincoln Amendment are the law of the land, and the challenge now is implementation.

Paul Volcker has expressed frustration with the implementation process, arguing that his idea for the rule is a simple one and that good regulators should know proprietary trading when they see it. He believes a short, simple rule is called for. The problem for regulators is turning that sentiment into clear guidance for securities firms engaged in trading activities. Regulators cannot be expected to make a determination that a firm has violated the rules if those rules are not clearly specified.

Rather than fighting the complexity of the Volcker Rule, it is better to acknowledge or even embrace that complexity by recognizing that it will take time and a serious effort of data analysis to get the rules right. A financial institution may buy assets in the expectation that these will be demanded by its clients and sold off quickly. If market conditions change, however, the institution may end up holding the assets for an extended period of time before they are all allocated to clients. The challenge is to discern when the firm is simply engaged in market making activity and when it is not. Another reason for real complexity is that markets for financial assets vary significantly. Some are thick, with a considerable volume of trading and billions of dollars changing hands on a daily basis. Other markets are thin with low levels of daily trading where a broker-dealer may have to hold a significant position in an asset over time in order to serve a client who, for example, wants to tap the capital markets for funds to invest.

There is already much controversy around the length of time it is taking to implement Dodd-Frank rules. To many critics of the regulators or the industry, the delays are symptomatic of foot dragging and an unwillingness to take the necessary steps to properly protect the financial system. Nonetheless, there are some cases where taking time is entirely appropriate and the Volcker Rule is one of those.The costs of a poorly implemented Volcker Rule would be high. Such a rule could reduce liquidity in financial markets and thus raise costs and reduce investment in the broader economy. All investors and savers would be affected.

I co-chair the Bipartisan Policy Center’s Financial Regulatory Reform Initiative and it has just released a report, authored by James Cox, Jonathan Macey, and Annette Nazareth, that proposes a path toward implementation of the Volcker Rule in a way that achieves the legislation’s intent while allowing capital markets to function efficiently. The report makes clear that the way to deal with the complexity of markets is to combine data and metrics to understand how the different asset markets vary, and use a similar process for different activities. In doing so, the relevant regulators would build a database to develop these metrics and then use them to monitor institutions for compliance with the Volcker Rule. Institutions must be able to track their own activities and know when they are approaching the line of proprietary trading and how to adjust their activities to avoid violations. The authors also argue that a well-implemented Volcker rule would also effectively implement the Lincoln Amendment. This approach could be a big step forward. The Volcker Rule and Lincoln Amendment are part of the law, but it is vital to get them right.