banking

Fed faces intense criticism over bank rule

Paul Volcker
Highlights
  • The Volcker rule has its origins in the financial reforms of the Great Depression.
  • The idea was that banks that take deposits shouldn't invest money for their own gain.
  • Some letters express criticism over the profusion of loopholes in the rules.

It's not a great week to be a regulator at the Federal Reserve. Spurred by a section of the Dodd-Frank financial reform law known as "the Volcker rule," the Fed has put together a set of rules designed to prohibit banks from investing their own funds, known as "proprietary trading," set to take effect in July.

But the Fed's efforts are being met with thousands of pages of critical letters from ordinary citizens, the global finance industry, and Wall Street critics demanding regulators change the rules to make them either more restrictive or more accommodating, depending on who's doing the writing.

The Volcker rule has its origins in the financial reforms of the Great Depression. Remember that scene from "It's a Wonderful Life" when all the banks in town have huge lines of angry citizens out front, demanding every dime of their money back? It's called a bank run, and if you've never seen one, it's because they rarely happen anymore. In times of trouble, banks can now depend on a helping hand from the federal government. This comes in the form of insurance from the Federal Deposit Insurance Corp. and access to money at low rates from the Federal Reserve.

Safety net for banks

Those two safeguards are a big part of why there were no bank runs during the most recent financial crisis. But it also presented a problem to policymakers, who believed having that safety net under banks encouraged them to make risky bets in global markets in the run-up to the financial crisis, leaving taxpayers and responsible banks holding the bag should those bets fail.

"The big banks do have access to the safety net, in the form of the Federal Reserve discount window, and they can rely fairly heavily on insured deposits to fund their activities," says Jim Barth, co-author of "The Guardians of Finance: Making Regulators Work for Us." "One has to be sure that banks, to the extent they have access to that safety net, don't misuse it."

The Volcker rule, so named because it was suggested by former Federal Reserve Chairman Paul Volcker, attempts to solve that problem by proposing what started as a simple rule: Banks that take deposits can't invest money for their own gain.

"The prohibition of proprietary trading by the big banks is based upon the notion -- I believe the mistaken notion -- that proprietary trading contributed in an important way to the most severe financial crisis since the Great Depression," Barth says.

But during the legislative process, that simple rule quickly ballooned to include a long list of exemptions to protect trading activities that policymakers considered essential to the operation of global markets. Here are some of the key exemptions.

  • Banks can invest their own funds in U.S. Treasuries.
  • Banks can still engage in risk-mitigating hedging activities.
  • Banks can still trade on behalf of customers.

Accommodating those exemptions while keeping the spirit of the law made things difficult for regulators. The Federal Reserve proposal ran to 298 pages, and it still received thousands of pages of criticism from everyone from consumer advocates to foreign banks to financial industry trade groups.

Financial industry objections

It's not surprising a long list of U.S. and international banks, including U.S. Bank, JPMorgan Chase & Co., Morgan Stanley and PNC Financial, and trade groups such as the American Bankers Association object to the new rule, Barth says.

"Banks like to earn profits, not be prohibited from doing so, which the Volcker rule does in part," Barth says.

If the rules are implemented as written, many U.S. banks and foreign banks with U.S. subsidiaries will have to spin off their profitable proprietary trading operations and potentially cut a lot of jobs in the financial industry.

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