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Newton’s Law and the Volcker rule

By Mark Hamrick ·
Tuesday, December 10, 2013
Posted: 5 pm ET

Some of us remember Newton's Law from our school days: Every action has an equal and opposite reaction. Case in point: the Volcker rule.

More than five years after the financial crisis, we are still seeing reactions. They include today's rare alignment of five federal regulatory bodies, hoping to discourage risky activity on the part of banks blamed for nearly sinking the U.S. economy.

More than two years after the landmark Dodd-Frank financial reform law was signed by President Obama, calling for adoption of the Volcker rule, regulators have given final agreement to what it should be. The rule, named after the former Federal Reserve Chairman, attempts to ban many kinds of proprietary or profit-seeking trading by banks. It also would limit investments in hedge fund and private equity. Banks have until July 2015 to begin complying.

In the new rule, regulators drilled more deeply into its proposed restrictions: The final rules prohibit insured depository institutions and companies affiliated with insured depository institutions ("banking entities") from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account. The final rules also impose limits on banking entities' investments in, and other relationships with, hedge funds or private equity funds.

Peter Morici, professor of business at the University of Maryland, offers this breakdown of the new regulation: "The rule limits bank purchases of stocks, bonds, currency, commodities and derivatives contracts that bet on movements in the prices of assets-with their own money, which also put their federally insured deposits at risk."

Regulators promise that the rule would ban the kind of trading that led to a $6 billion trading loss at JPMorgan Chase & Co.

The Volcker rule is complex at nearly 1,000 pages after some 18,000 public comments on the proposal, and lobbyists for the financial industry have certainly weighed in.

Senate Banking Committee Chairman Tim Johnson, D-S.D., called final approval "a key milestone in the full implementation of Wall Street reform and these trading restrictions will help improve the integrity of our banking system."

It is often the case that even well-meaning change can produce unintended consequences.

Trading restrictions

Reports have indicated that some of the traders who've worked for large banks already have departed for the hedge fund industry. That raises the fear in some quarters that the unregulated portions of the markets present dangerous risk for the broader economy.

"It's going to drive a lot of this kind of activity into the shadows and help to stimulate a resurgence of 'shadow banking','' or financial entities that provide services outside of regulatory oversight, says Bert Ely, a banking consultant with Ely & Co. "We're going to have players out there that are not subject to this rule, like hedge funds, that see some opportunity here to make a few bucks."

Limit on banking services?

Will the rule make it difficult for firms to do business? That seems to be the suggestion of the American Bankers Association. "Unfortunately, the Volcker rule will still make it too hard in too many cases for bankers to provide services that many bank customers rely upon every day, posing no risk to the financial system," CEO and President Frank Keating says in a statement.

There's more to come, including the question how regulators handle enforcement of the Volcker rule and any new regulations. Supporters of aggressive reform would like to see a reinstatement of the Depression-era Glass-Steagall law, separating banks and securities firms.

"The strongest protection for consumers, taxpayers and the financial system will come with the passage of the complete separation of commercial and investment banking through the 21st century Glass-Steagall Act," said Bart Naylor, with Public Citizen’s Congress Watch.

As new fixes come online, the financial industry may continue to feel the effects of Newton's Law, with industry players wondering what the unintended consequences will be.

Follow me on Twitter: @hamrickisms.

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