Whether you like your news real, fake, or Fox, you’ve probably heard about the recent push for increased Wall Street regulation to reform the risky banking practices that resulted in the 2007 financial collapse. Back in 2010 when members of Congress actually did their jobs, the Senate passed the Dodd-Frank Act, which aimed to reform the industry by increasing federal regulatory powers and oversight.
Federal regulatory agencies are set to vote on Tuesday on the Volcker Rule – a key provision of the Dodd-Frank Act that banned certain types of proprietary trading and hedging. Proprietary trading is the kind of trading you hear Rachel Maddow or Jon Stewart rail against for hours: where banks invest for their own profit, not their clients’ profit, using federally-insured taxpayer money to finance high risk trades.
Now that may not sound so bad – mostly because the ‘simple explanation’ could still be lost in translation. To really illustrate the concept of proprietary trading, think back to the economic crisis of 2007. Banks issued loans to people with terrible credit who might never pay them back, known as subprime loans. Investment banks then bought these subprime loans and bundled them into mortgage backed securities, or basically a sellable bundle to be handed off to willing investors (usually Fannie Mae or Freddie Mac). Unsurprisingly, those loans were never paid back, the housing market crashed, and once there was no interest payments or property value, mortgage backed securities become useless.
Basically, the banks went to Vegas with the taxpayers’ money and lost it all at the blackjack table (or they blew it on hookers and cocaine, which may be closer to the truth).
Many lawmakers believe that the Volcker rule could change Wall Street’s wicked ways, though. The Volcker Rule, named after former Federal Reserve chair and current Obama advisor Paul Volcker, faces the challenge of defining exactly what proprietary trading is in the context of the law. Regulators can rest assured that corporate lawyers are already printing out all 970 pages of the rule, looking for loopholes big enough to hide some risky business. The rule is more “gray” than the sides of Mitt Romney’s hair, ladies and gentlemen.
The anticipated version of the rule is expected to allow for market making activity, even though it technically falls under the umbrella definition of “proprietary trading”. Market making activity – when a broker “creates” a market for a stock by being ready to buy and sell an infrequently traded stock, allowing investors to cash in their holding at the broker’s designated price– will not be in danger by definition, but making the distinction between proprietary trading and market making activity won’t be easy for the regulators. Especially when the regulators are the banks themselves.
Yes, you heard right. When this law is eventually implemented in July of 2015, CEO’s are going to be responsible for attesting to their bank’s compliance with the rule. Self-reporting seems a bit idealistic on the part of the government, considering they are trying to regulate an industry that makes its livelihood through a persistent asymmetry of information. To the banks’ credit, though, Goldman Sachs, Citigroup, JPMorgan Chase, and Morgan Stanley have preempted the regulation and ended their proprietary trading branches to comply with the Dodd-Frank regulations.
Further complications arise when considering the bond market. While stock trades are made on a central exchange, the bond market relies on trades through dealers, and therefore each dealer must own the bond before selling it to someone else. Such trades are not necessarily the risky trades the rule means to prevent, but they definitely fall in the gray area.
Yes, there are holes and gray areas in the Volcker rule. Yes, there are clever lawyers and traders who will climb through the holes and wade through the murky gray waters. But there is no doubt that Wall Street needs to be reigned in, and the Volcker rule is a good place to start.
For anyone worrying about the Volcker rule collapsing the banks with regulation, take a look at the 1933 Glass-Steagall Act that separated commercial and investment banking practices for 66 years – banks survived with even stricter regulation. The Volcker rule is just a step in the right direction – not a step on Wall Street’s toes.