Will the Volcker Rule’s Complexity Be Its Undoing?

Regulators today face evolving challenges in an increasingly complex financial world. Some of these challenges include protecting taxpayers, allowing for organizational autonomy, and promoting economic stability. One recent effort to address such concerns is the Volcker Rule, designed to prevent some of the main causes of the 2008 financial crisis. While many believe it was a good idea, some have highlighted its deep complexity and doubt whether the rule can be implemented successfully. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) is one of the most significant regulatory reforms in the financial industry since the passing of the Securities Acts of 1933 and 1934, which instituted thorough registration and reporting requirements for publically traded companies in the wake of the Great Depression. Just as the Securities Acts were designed to protect consumers after the Great Depression, Dodd-Frank was born out of the Great Recession of 2008. The Volcker Rule, a centerpiece of Dodd-Frank, is among the most hotly debated portions of the Act. In its simplest terms, the Volcker Rule prohibits banks from engaging in proprietary trading and from having certain relationships with hedge funds and private equity funds. Proprietary trading is a high-risk form of trading where banks use client accounts to trade for direct gain. When the risks pay off, a bank can stand to gain significant returns. However, when banks use their clients’ money to engage in risky investments and then lose, taxpayers bear the brunt of the loss, as the Federal Deposit Insurance Corporation insures this money. The Volcker Rule is intended to prevent this problem by ensuring that high risk trading is left to hedge funds and other smaller institutions that, should they fail, would not destroy the economy. While this strategy may seem simple and straightforward, the rule itself is so complex and often debated that banks may fail to comply or may even seek to exploit loopholes and demand special treatment. The rule’s complexities begin with its many exceptions. For example, while proprietary trading is banned generally, there is an exception for trading in U.S. government, agency, state, and municipal obligations, and an exception for when a bank allocates the risks associated with equities trading to its foreign entities. The Volcker Rule’s unique complexities could mean that its enforcement is particularly difficult. The final version of the Volcker Rule distinguishes between trading that is based on market speculation—generally self-serving and impermissible—and those permissible trading activities that are designed to benefit clients and lessen a bank’s exposure to risk. While a bank is required to demonstrate that its trades are linked to its clients’ needs, determining whether some trades were made merely under the guise of permissible activity can be difficult because often there is very little evidence of impropriety in those cases. Furthermore, the rule is not always clear about what constitutes a violation. Without a clear standard and enough evidence of misbehavior, regulators may be forced to make hard determinations case-by-case. In addition, administration of the rule itself presents challenges. The Volcker Rule was promulgated by five administrative agencies that possess different enforcement mandates. These agencies don’t always agree about what constitutes proper banking activities. Because banks will be subject to oversight by at least three of these agencies, regulators may disagree about whether or not a given action constitutes a violation. This risk for varying interpretations is especially high in this case, as the agencies’ views over how to regulate banks derives from their differing historical mandates: the banking-focused regulators, who monitor the safety and soundness of a given bank, tend to be more concerned with internal matters (for example, a bank’s capital holdings level) while the securities regulators, who focus on protecting investors and the functioning of financial markets, pay more attention to the risks associated with buying and selling assets. These differences heighten the risk of inconsistent application of the rule. Ultimately, if the Volcker Rule “lacks bright-line distinctions,” its enforcement will burden the enforcing agencies. Some analysts expect day-to-day compliance to be extremely expensive, time-consuming, and complex. Although the rule’s authors left some areas grey intentionally to ensure that banks have some wiggle room as they engage in legitimate buying and selling, the agencies will have to make the ultimate judgments regarding compliance. The success of the Volcker Rule rests upon whether federal regulators will succeed in enforcing the “spirit as well as the letter of the law” as they monitor the powerful banking industry. While no one can know yet whether the Volcker rule will be a successful pillar of financial reform (or instead that complexity will kill this proverbial cat) mandatory compliance begins July 2015. This is part two of a three-part series featuring winning essays of a Penn Law administrative law writing competition