Bloomberg: Maybe the Fed did not guy Volcker rule

Bloomberg View Editorial

The U.S. Federal Reserve has moved forward with a proposal to alter one of the most-debated elements of the 2010 Dodd-Frank financial reform: The Volcker Rule, designed to limit banks’ ability to gamble with taxpayer money. Critics have attacked the plan as an effort to neuter the law.

This needn’t be so. How much of a rollback the change will be depends on how regulators choose to enforce it.

As written in Dodd-Frank, the rule presents a difficult task. Regulators must prevent federally insured financial institutions from speculating, but must also allow some activities that can be indistinguishable from it – notably market making, which involves trading securities and derivatives to satisfy customer demand.

For the past few years, regulators have tried to make the distinction by getting into traders’ heads. They presumed that all positions held for less than 60 days were speculative unless proven otherwise, and told banks to produce a slew of data meant to shed light on traders’ intent. As the regulators themselves admit, this has proven both burdensome and unhelpful.

Now, the Fed is proposing a simpler approach. It wants to scrap the 60-day rule and many of the metrics, and instead focus on outcomes. If banks set reasonable limits for risk measures such as profit and loss, and stay within them, it will assume they are complying with the law. It will also tailor the rule to banks’ size: Those that do not do much trading will largely get a pass.

In principle, all this makes sense. The Volcker Rule’s goal is to prevent trading activity from putting taxpayers at undue risk (as opposed to restricting lending, which taxpayers explicitly support though deposit insurance and emergency Fed loans). Profit and loss from the activity is a pretty good measure of that risk. If market making stays within reasonable limits, it does not matter what traders are thinking.

The key, then, is that regulators choose the right risk limits. If these are too lax, a lot of unwanted proprietary trading will seep through. If they are tight enough, it’s true that they will probably inhibit some market making as well – such as buying a difficult-to-hedge bond from a customer in a volatile market. But that is the price of curbing speculation.

There are better ways than the Volcker Rule to limit the scope of taxpayer subsidies – but they aren’t happening any time soon. Done right, the Fed’s proposed approach could make the regulation in place both more effective and less burdensome. But it all depends on the details. Over the next couple of months, while the proposal is out for public comment, regulators should make their exact intentions known.

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