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New Fed Management, New Volcker Rules

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Federal Reserve Chairman Jerome Powell. Photo courtesy the Federal Reserve.

Central bankers are not known for their love of simplicity, but the new management at the Federal Reserve seems to recognize that making a rule understandable and practical is as good for its enforcers as it is for those trying to follow it.

The Fed unanimously approved a proposal this week that will revise the Volcker rule in order to make it less opaque and less burdensome. “Volcker 2.0,” as some commentators have dubbed it, would divide banks into three categories based on size and tailor compliance requirements accordingly. The biggest banks – those with at least $10 billion in trading assets and liabilities – would need to comply with the strictest (though still somewhat easier) provisions in the rule, while banks with less than $1 billion would have most compliance burdens lifted. Overall, the newly revised rule would shift the burden of proof; instead of bankers proving that each of their trades complies with the rule, regulators will have to demonstrate an alleged infraction.

These changes aren’t yet final. Four other banking regulators must also approve the changes in separate votes. If, as expected, they support the Fed’s proposal, the public will have 60 days to comment before it moves forward. Regardless, the revision represents a step toward a more reasonable regulatory framework.

In his opening statement to the proposal presentation, Fed Chairman Jerome Powell said: “We have had almost five years of experience in applying the Volcker rule. The agencies responsible for implementing the rule see many opportunities to simplify and improve it in ways that will allow firms to conduct appropriate activities without undue burden, and without sacrificing safety and soundness.” In other words, five years in, even the rule’s enforcers are ready to rewrite it.

Paul Volcker, the former Fed chairman for whom the rule was named, weighed in too. In a statement, Volcker said that he welcomed efforts to simplify compliance as long as the rule’s core idea, preventing proprietary trading at odds with customers’ interests, remained intact.

The Volcker rule, like much else in the 2010 Dodd-Frank Act, initially served to demonstrate that lawmakers were doing something – anything – in response to the 2008 financial crisis. Instead of taking a sensible approach to solving a demonstrably real problem in the financial world, the financial reform law instead made life hard for banks for the express purpose of allowing its authors to talk about how tough they were on bankers.

After the financial crisis, regulators wanted to limit the riskiest of banks’ speculative activities. The Volcker rule as it stands – call it “Volcker 1.0” – was intended to restrict proprietary trading. However, both regulators and banking industry players have since pointed out that the rule’s complexity has made it difficult to comply in good faith, especially considering the often fine line between proprietary trading and routine banking activities, such as offsetting risks via hedging. The heavy compliance load has also burdened banks in a variety of ways, causing trickle-down effects for customers.

Predictably, the law of unintended consequences kicked in shortly after the Volcker rule came into force. As I recently wrote, we can see the original Volcker rule’s effects in our economy today in the form of reduced liquidity and the resulting problems it has caused, especially as volatility returns to a long-tranquil market.

The changes that the Fed proposed are likely to address some of the worst side effects of the financial crisis overreaction that the Volcker rule represents. In addition to reducing the compliance burden on smaller institutions, the proposal also allows banks to hold stakes in hedge funds or private equity funds on behalf of customers that are not banks. Banks would also be able to trade for their own profit within circumscribed limits, something the original Volcker rule prohibited.

Regulators have indicated that this change is the first step, not the finish line. Randal Quarles, the central bank’s vice chairman for supervision, said in a statement, “[…] I view this proposal as an important milestone in comprehensive Volcker rule reform, but not the completion of our work.” Some Dodd-Frank supporters had worried that the Volcker rule would be gutted, or even scrapped, but the Fed’s proposal instead represents a reasonable correction that will help banks get back to banking.

As Barclays analyst Jason Goldberg noted of the proposal, if adopted it “is not expected to be a home run” for large banks, “but potentially a solid single.”

We are finally getting around to using financial regulation as a tool to try to anticipate and alleviate real-world problems, rather than as a tool to punish banks for allegedly causing the financial crisis. We are likely to be better pleased with the results this time.

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