The draft Volcker Rule proposal memo that American Banker got its hands on and published today is a pretty impressive piece of work. As a reminder, people thought that a reason 2008 was so unpleasant was that banks engaged in too much risky proprietary trading. So the testudinal gentleman to the right suggested, and Congress passed, a rule to rein in risk by banning FDIC-insured banks from proprietary trading.

But that’s hard to do, since the basic securities functions of a bank – making markets for customers, and hedging risks in its market-making book or in its regular old deposits-and-loans banking activities – require trading for its own account. So the agencies implementing the rule came up with a rule proposal that sets out, in 200 pages with lots of Q&A in case you have better ideas, to figure out how to distinguish bad “proprietary trading” from good “permitted trading.”

On a first read, er, skim, it’s really smart. It looks at a bunch of different metrics to distinguish market making from prop trading, like:

- Are you actually making two-sided markets, seeing two-sided flow, etc.?
- Are you accumulating more inventory than you could possibly find a use for?
- Are you making more money from commissions/fees/spreads or from inventory appreciation?
- Are you paying people based on commissions/fees/spreads or on inventory appreciation?
- Other stuff. Really, just so much other stuff.

Here’s my favorite part, from pages 106-107 if you’re following along at home. To set the scene, the rule bans “proprietary trading,” which is defined as short-term trading by a bank as principal. But that ban does not apply to “permitted trading activities,” which include market-making and hedging. *But*, certain kinds of “permitted trading activities” go back to being not permitted, including trading activities that raise “material conflicts of interest” (“you sold me a security that was designed to fail!”) or that expose the bank to “a high-risk asset or a high-risk trading strategy.” Got that? Okay, now:

Section __.8(c) of the proposed rule defines “high-risk asset” and “high-risk trading strategy” for proposes of § __.8’s proposed limitations on permitted trading activities. Section __.8(c)(1) defines a “high-risk asset” as an asset or group of assets that would, if held by the banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail. Section __.8(c)(2) defines a “high-risk trading strategy” as a trading strategy that would, if engaged in by the banking entity, significantly increase the likelihood that the banking entity would incur a substantial financial loss or would fail.

A footnote says that banks should have a way to figure out what is a high-risk activity, and waves at “significant embedded leverage” as maybe an indicator.

Well okay. The thought process is:
- Prop trading is risky
- Let’s ban prop trading
- Here, in 200 pages of overlapping qualitative and quantitative factors, is a comprehensive definition of prop trading
- But we may have missed something that causes risk
- So let’s also ban anything else that is risky
- And you figure out if it’s risky or not

That’s cheating! You had 200 pages to define everything that you thought was risky, why do you need to include this extra “don’t do anything else risky either” rule? Or, put another way: if you’re going to have a rule saying “don’t do anything risky,” why do you need the other 200 pages?

It would be nice to think that regulators can figure out how to keep banks from losing money, write it all down – even if it takes 200 pages – and leave it to banks to carry out. Of course, it would be surprising if that were the case: if anyone has the incentives and expertise to keep banks from losing money, it would be banks – and so far their performance has been so-so. The mammoth draft Volcker Rule is an impressive effort to understand and specify the distinction, hard to draw precisely, between proprietary and market-making-and-hedging activities. But if you want to know whether all this careful definitional work will prevent another bank meltdown or financial crisis, the fact that the regulators felt the need to add “and don’t do anything else risky either” at the end is not all that hopeful a sign.

Cheat Sheet: Details of the Long-Awaited Volcker Rule [AB]

Comments (63)

  1. Posted by Backdoor_Bess | October 6, 2011 at 3:07 PM

    If I could blow myself up, well, I would never leave the house.

  2. Posted by Pierce Inverarity | October 6, 2011 at 3:08 PM

    Call me crazy, but, how about, I dunno, just reinstating Glass-Steagall so federally insured banks can't engage in investment banking at all?

  3. Posted by IgnorantBastards | October 6, 2011 at 3:21 PM

    what is he looking for behind his head?

  4. Posted by Milksteak | October 6, 2011 at 3:27 PM

    I don't have a problem with the end sentence, it's kind of like the caveat I give to people (girls) regarding attending events I don't feel like going to.

    "yeah, I'll definitely try to make it, probably." Vague and non-committal, that's the name of the game.

  5. Posted by PermaGuestII | October 6, 2011 at 3:34 PM

    At least the Adminstration came up with a way to employ all those out-of-work law school grads.

  6. Posted by Alt_EST | October 6, 2011 at 3:47 PM

    I just blue myself.

    -T Funke

  7. Posted by Guest | October 6, 2011 at 3:52 PM

    You're crazy….Thats logical AND makes sense. How could these 'tards figure something like that out

  8. Posted by UBS ETF Trader | October 6, 2011 at 3:53 PM

    Wait… what's a hedge?

  9. Posted by pazzo83 | October 6, 2011 at 3:57 PM

    Yep. Clearly such an idea has no place in good ole DC.

  10. Posted by Texashedge | October 6, 2011 at 4:19 PM

    It certainly would save a lot of W.A.S.T.E.d paper, wouldn't it Pierce?

  11. Posted by K.Adoboli | October 6, 2011 at 4:57 PM

    I was sorta under the impression that it was the government's responsibility to prevent banks from failing while we invent new ways to blow them up … ____Good thing that's all cleared up now.

  12. Posted by jumbo | October 6, 2011 at 5:15 PM

    Telling banks not to do anything "risky", then failing to define what is risky creates a legal loophole big enough to rival the hole in Morgan Stanley's balance sheet.

    Good luck to the government regulators/litigators who have to prove in court that a bank was knowingly undertaking risky behavior in violation of the rule … you know, unless the bankers are stupid enough to write emails about how shitty some of the deals are.

  13. Posted by Jay | October 6, 2011 at 6:06 PM

    Why was he looking at me when he proposed it?

    - Kweku

  14. Posted by Spanishmoon | October 6, 2011 at 6:08 PM

    Matt:

    Back when you were in diapers, we old-timers worked at places called "investment banks". We took risks with partner capital, not depositors' funds. Banks handed out toasters to depositors. We traded.

    You can't be half pregnant or half-subsidized.

    Few of you kids are going to have jobs on the Street if we don't get these asshole, incompetent banks out of the business before they destroy it for the rest of us.

    Sorry. End of sermon.

  15. Posted by MeVC | October 6, 2011 at 6:50 PM

    When not busy writing rules, Mr. Volcker films commercials for Six Flags Entertainment Group as the Mr. Six character.

  16. Posted by TOF | October 6, 2011 at 8:01 PM

    JFC TLDR

  17. Posted by Guest | October 6, 2011 at 9:49 PM

    You are aware that BSC, LEH, and MER were never banks, and while during 2008 GS and MS became bank holding companies in order to have access to the Fed window they did not and still do not have any FDIC-insured deposits? You are further aware that had Glass-Steagall been in effect, JPM would not have been able to buy BSC, BAC would not have been able to buy MER, and LEH would have had to liquidate everything because Barclays wouldn't have been allowed to buy its operations out of bankruptcy (well, perhaps Barclays could have still have bought it- I forget what Glass-Steagall had to say about foreign banks with foreign deposits)? Not only would Glass-Steagall completely failed to prevent the crisis, it would have made it vastly worse. It was in effect during the LTCM mess and had no part in preventing a very near meltdown. It was in effect during the S&L crisis and there still had to be a big federal bailout.

    Please explain how Glass-Steagall would do anything useful

  18. Posted by DKWC | October 6, 2011 at 10:07 PM

    "I'm sorry regulator, I didn't know I couldn't do that"

    -Because I DID know I couldn't that!

  19. Posted by guest | October 6, 2011 at 10:22 PM

    Co-signed.

    -45 year old guy who remembers

  20. Posted by Phyllis Dean | October 6, 2011 at 10:38 PM

    Yes they have FDIC insured deposits, just very very few. To be a BHC you must own a bank, to be a bank you must accept deposits and make loans.

    CHECK YOU CALL REPORT

  21. Posted by Spanishmoon | October 7, 2011 at 11:10 AM

    Wrong. Merrill Lynch owned a very large bank before BAC took it over. Look it up.

    MS has a bank today with insured deposits. Before they spun off Discover, it had a very large bank. I have money in MS's bank today. Otherwise their big retail customers would have bailed out long ago.

    You analysis is post hoc, ergo propter hoc. Flawed logic. None of the SIVs, derivatives, MBS conduits etc. ever would have existed on the balance sheets of commercial banks under G-S.

    Investment banks have been blowing up since the beginning of finance. Civilization continued.

    Putting G-S back on the books will get these idiot banks out of trading and make the system safer. Otherwise, we are all going to lose our jobs when one of these big banks blows itself up and the OWS people bring guns to the next protest.

  22. Posted by Pierce Inverarity | October 7, 2011 at 3:00 PM

    Non sequitur. You're arguing something not on the board.

    The issue at hand is this: instead of initiating innumerable new regulations and the unforeseen consequences (and loopholes) that result, why not merely default back to a clean, simple rule that worked fairly well for 66 years.

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