Livinglies's Weblog

Paul A. Volcker is a giant of financial history. He played a behind-the-scenes role when the United States abandoned the gold standard in 1971. He restored credibility to the Federal Reserve and slew inflation a decade later.

In what would have been retirement years for anyone else, he became chairman of the group overseeing the International Accounting Standards Board and guided it to a level of independence that outraged French banks.

Now, at 83, he finally has something named for him. The question is whether it can be effective.

The Volcker Rule was part of the Dodd-Frank Act that Congress passed last year, barring banks from engaging in “proprietary trading.”

When Mr. Volcker proposed it, the big banks at first wanted to kill it. But it became clear that the combination of his prestige and the bank’s own bad reputations meant that something was going to pass.

So the banks settled for trying to hobble the rule with exceptions and qualifications.

Now it is up to regulators to adopt rules.

This week the Financial Stability Oversight Council, which was also created by Dodd-Frank and is led by the Treasury secretary and includes other financial regulators, put out a study and recommendations on the issue, providing at least a road map toward the rules that will come out within a few months.

The hurdle they face is simple: there is no easy way to tell a proprietary trade from another kind of trade, particularly given the exemptions worked into the law.

As the study noted on its first page, “These permitted activities — in particular, market making, hedging, underwriting and other transactions on behalf of customers — often evidence outwardly similar characteristics to proprietary trading.”

To some extent, regulators have made it easier for banks to continue trading. The biggest potential loophole is market making, and the study took a broad view of that. It made clear that market makers may acquire securities because they expect customers to want them, not just because they already have orders.

That means, wrote Jaret Seiberg, an analyst with MF Global, that they “need not worry that miscalculating customer demand would result in large penalties.” He added that “this seems even more positive than industry was expecting. The biggest banks would benefit the most from adoption of this type of proposal.”

But that goody may be more than balanced by the overall tenor of the report, which repeatedly cautions that regulators must be on the outlook for efforts to evade the rules.

“I think it is a good-faith effort to enforce what the law asks for,” Mr. Volcker told me this week, after reading the report. “It makes clear you cannot hide proprietary trading in other activities. It strikes me as very straightforward.”

Straightforward may not be the word that some bankers will choose. They had hoped for clear rules that could be complied with — or evaded, if you want to be cynical. Instead, they got a lot of advice for regulators on how to monitor bank trading to see if it complies, using statistics invented for other purposes, like risk measurement.

Do banks tend to make the most money from a trade on the first day, rather than over time? Does the inventory of securities turn over quickly? Are daily profits relatively consistent? Negative answers could indicate proprietary trading and provide a reason for bank examiners to descend on a trading desk.

I have another metric that they might consider. What are the traders paid? If a trader is collecting millions in salary and bonus, you have to wonder whether he or she is merely trying to satisfy customer demand, as opposed to time markets.

The use of all those metrics, along with requirements for banks to monitor them and have clear policies, sounds scary to some. Winthrop N. Brown, a partner at Milbank, Tweed, Hadley & McCloy who represents banks, said the council had done a good job in general, but “I would be troubled if I were a chief compliance officer. It seems to be very burdensome.”

The Sarbanes-Oxley Act in 2002 accomplished something with a provision that I thought superfluous, and the council picks up on that by suggesting that chief executives be required to certify that their banks are in compliance with the Volcker Rule, just as the earlier law forces them to certify the accuracy of financial statements. It turned out that certification concentrates attention, even if it does not change the underlying legal requirements.

Some think the concentration on proprietary trading is a little ridiculous. It was not, after all, such trading that produced the financial crisis. That came from bad loans and botched securitizations of such loans. Nothing in the Volcker Rule affects lending, and the law specifically says it is not to be used to hamper securitizations.

When I put that to Mr. Volcker, he pointed both to the problems at Société Générale, the French bank that lost billions of euros because of a rogue trader, and to Bear Stearns, the first casualty of the financial crisis. Bear’s problems first emerged in a hedge fund it ran, which it bailed out in an effort to preserve its reputation. Eventually, a liquidity crisis brought the bank down.

The new law tries to limit that by restricting bank investments in hedge funds. They can start them, but within a year are supposed to have a stake of no more than 3 percent.

There would be a case for the Volcker Rule even if such trading had not caused problems in the past. Banks are special, simply because they have deposit insurance, and there are limits that need to be imposed on the risks that such government-guaranteed banks take.

Of course banks can take plenty of risks without engaging in proprietary trading. Bad loans have brought down many a bank. But bank lending is something that society wants to encourage. Other forms of speculation may be perfectly reasonable, and even highly profitable much of the time, but their societal benefit is far less clear. Those who wish to gamble in that way ought to do so without such insurance.

In the end, the Volcker Rule may work, even if there are ways around it. Is it really worth the effort to dodge rules to do things that would be perfectly legal if someone else did them? If the regulators do put in the effort, the answer may be that few banks will bother.

Mr. Volcker himself professes optimism.

“I may not understand modern financial attitudes,” he said, “but I don’t think a bank wants to be conducting financial activities that will be revealed as simply skirting the law.”

That optimism is, however, based on the assumption that regulators will put in the effort. For now, that is probably a good assumption. But it is worth noting that regulators are being asked to do a lot without a commensurate increase in resources. That may not hurt the Fed, which sets its own budget, but the Securities and Exchange Commission is getting stretched very thin and the new Republican House leadership shows no interest in fixing that.

The S.E.C. this week put out a report on inspections of financial advisers, as required by Dodd-Frank. The staff concluded that the commission would not have the resources to do enough inspections, and asked Congress to either allow it to impose fees on advisers to pay for the inspections or assign the task to self-regulatory organizations, which could impose similar fees.

One commissioner, Elisse Walter, voted to release the study but argued that it did not go far enough.

“We need to address this issue now,” she concluded. “For far too long, in the investment advisory area, the commission has been unable to perform its responsibilities adequately to fulfill its mission as the investor’s advocate, and investment advisory clients have not been adequately protected. This must change.”

Regulatory priorities come and go. For now the Volcker Rule seems important, but then we are only a couple of years removed from the Madoff scandal. Yet it seems unlikely Congress will provide the needed resources to assure there are adequate inspections of money managers.

It may not be that many years before some banker concludes the possible profits from speculative trading are attractive enough to justify trying to get around a rule whose enforcement no longer seems to be a priority.