Rule that curbs bank risk-taking nears approval
Wall Street is entering an uncertain new era as the rule that has come to symbolize Washington's efforts to rein in financial risk-taking finally takes hold.
Five years after the financial crisis, federal regulators are poised to approve the so-called Volcker Rule, the keystone of the most sweeping overhaul of financial regulation since the Depression. The rule, a copy of which was reviewed by The New York Times, imposes some requirements that are tougher than the banks had hoped.
Five federal agencies are expected to vote to approve the rule on Tuesday, representing a potential shift in the balance of power in financial reform as regulators gain more leverage over the largest banks. Although it counts as only one of 400 rules under the Dodd-Frank financial overhaul law — and nearly two-thirds of the regulations remain unfinished — the Volcker Rule became a litmus test for the overall strength of the law.
(Read more: Why I'm voting no to Volcker: SEC commissioner)
But the rule, which aims to draw a line between everyday banking and Wall Street wheeling-dealing, is no panacea. Some critics say the rule, which regulators agreed to delay until July 2015, does not go far enough.
For its part, Wall Street is expected to scour the rule for loopholes and consider whether to challenge it in court.
At its core, the rule bans banks from trading for their own gain. The practice, known as proprietary trading, is one of Wall Street's most lucrative — and riskiest — activities.
Supporters of the Volcker Rule, the brainchild of Paul A. Volcker, a former Federal Reserve chairman and adviser to President Obama, said it would help prevent the buildup of the kinds of risky positions that nearly sank Wall Street in 2008. And they argued that, to help prevent future bailouts of Wall Street, large banks that enjoy forms of taxpayer backing should not use customers' money to make bets on the direction of stocks and bonds.
(Read more: Wall Street frets as Volcker Rule nears vote)
In recent weeks, regulators who favored a more stringent version of the rule pressed for changes that they think will make it harder for banks to evade the regulation. The version of the rule reviewed by The Times shows that, in some areas, the hard-liners got their way.
The rule, for example, includes new wording aimed at the sort of risk-taking responsible for a $6 billion trading loss at JPMorgan Chase last year. The bank contended it was trading to hedge its broader risks, but in fact it built a sprawling speculative position that spun out of control.
To prevent such blowups, according to the version of the rule reviewed by The Times, it will require banks to identify the exact risk that is being hedged. The risks, the rule said, must be "specific, identifiable" rather than theoretical and broad.
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The Volcker Rule also takes a swipe at the bonus culture of Wall Street, requiring banks to shape compensation so that it does not reward "prohibited proprietary trading." In addition, it requires chief executives to attest that they have established programs for complying with the rule.
"The C.E.O. of the banking entity must, annually, attest" to regulators that the bank "has in place processes to establish, maintain, enforce, review, test and modify the compliance program," according to the copy reviewed by The Times, which is dated Friday.
In an October 2011 draft of the rule, regulators did not include such a mandate, in contrast with the tougher tone of this version.
But it could have been even tougher. Some critics of Wall Street wanted the executives to attest that their bank was actually in compliance with the rule, not just taking steps to comply.
The banking industry is also expected to keep up its fight against the rule. Wall Street lobbyists opposed the Volcker Rule more fiercely than any other regulation that has come from the Dodd-Frank law, which Congress passed in 2010. They argued that trading was not a primary cause of the financial crisis and that the Volcker Rule could actually prevent banks from carrying out safe activities, like hedging against risks.
Now that the final version of the rule has emerged, lawyers and lobbyists are likely to seize on the fuzzy nature of proprietary trading, which can resemble more legitimate forms of trading essential to doing business on Wall Street.
The rule, for example, allows banks to buy and sell securities if they show that the purchases are to meet the demands of their customers, a practice known as market-making. But banks, under the guise of market-making, could build a proprietary position in shares of Google, for example, contending that at some point clients might buy the shares.
The question is whether the wording of the Volcker Rule is strict enough to force banks to stockpile securities only for customers. The version reviewed by The Times shows that while regulators adopted some measures to prevent banks from masking their proprietary bets as market-making, the rule may still be vulnerable to evasion.
(Read more: Volcker Rule spotlights CEO responsibility)
Indeed, the rule says that banks can build up positions to meet "the reasonably expected near-term demands of clients, customers or counterparties." Banks and regulators may clash over what is "reasonably expected," and the rule leaves it largely up to banks to monitor their own trading.
The rule also allows banks to do proprietary trades in bonds issued by governments. United States banks can make bets with Treasuries and even municipal bonds. In a significant concession, the Volcker Rule allows the foreign affiliates of United States banks to trade in bonds issued by foreign governments.
Under the rule, banks can also place trades that are meant to offset the risks posed by positions they hold, an activity known as hedging that can resemble proprietary trading.
The five federal agencies writing the rule — the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation and the Comptroller of the Currency — were divided over how tough to make the hedging language.
(Read more: More measures needed to secure banks: Treasury's Lew)
While some officials at the Fed and the S.E.C. have wanted to allow banks significant flexibility to carry out trading that is considered important for their health and the functioning of markets, Gary Gensler, the head of the Commodity Futures Trading Commission, sought to eliminate loopholes.
So when the Fed sent out a draft last month that removed a sentence that required hedging to be "reasonably correlated" with a bank's risks, people briefed on the matter said, Mr. Gensler and another agency commissioner, Bart Chilton, pushed back. And in recent days, they persuaded the Fed to insert into the rule a provision that requires banks to conduct a "correlation analysis" as well as "independent testing" to ensure that the trades used for hedging "may reasonably be expected to demonstrably reduce" the risks.
To further prevent banks from masking proprietary trading as a hedge, the rule required banks to conduct an "ongoing recalibration of the hedging activity by the banking entity to ensure" that the trading is "not prohibited proprietary trading."
(Read more: Fed could be about to make a major policy change)
The votes on Tuesday, which come more than a year after Congress required the agencies to complete the Volcker Rule, offer Wall Street a degree of clarity that once seemed remote. Until recent days, regulators appeared unlikely to meet the recommendation of Treasury Secretary Jacob J. Lew, who urged the agencies to complete the rule in 2013.
"For the banks, this is one of the most significant regulatory changes in decades," said Alan W. Avery, a partner at Latham & Watkins who represents financial institutions in regulatory issues. "It cuts off or fundamentally alters traditional sources of revenue for the banks."