Scary Capitalism

A Volcker Leap of 'Faith' 
The problem with too much regulatory discretion
WSJ Opinion, May 11, 2012

Thursday's surprise news of J.P. Morgan's $2 billion trading loss shows again why taxpayers don't want to stand behind Wall Street trading desks. But nailing down a precise definition of the Volcker rule, which was supposed to prevent taxpayer-backed gambling in the securities markets, is proving to be harder than forecasting changes in the Chinese politburo.

Even the seemingly mundane task of figuring out when the rule will take effect has become a challenge. A recent letter on Volcker from the Federal Reserve is Washington's latest monument to opacity.

Assistant editorial page editor James Freeman on what the Volcker rule would do and whether it could have prevented J.P. Morgan's $2 billion trading loss. Photo: Getty Images

Opting for hazy regulator discretion over bright statutory lines, a Democratic Congress joined with President Obama in 2010 to create Dodd-Frank. Among other things, the law purported to include former Fed Chairman Paul Volcker's concept to ban so-called proprietary trading at banks that enjoy federal deposit insurance. In other words, the banks could fulfill customer orders but they could not make trades for their own account. No more betting the firm's capital when the taxpayer is the ultimate backstop.

Writing the rule nonetheless proved too difficult for Messrs. Dodd and Frank. So after adding a few carve-outs to make sure that banks could still gamble on U.S. Treasury debt and bonds from Fannie Mae and Freddie Mac, the pols handed broad discretion to the bureaucracy to make the tough calls. Then Messrs. Dodd, Frank and Obama claimed to have reformed Wall Street.

Almost two years later the Fed still hasn't decided what the Volcker rule will say, but regulators have at least clarified when the rule will be enforced. Or have they? The April 19 letter from the Fed's Board of Governors began with a fairly straightforward message, confirming that "banking entities by statute have two years from July 21, 2012, to conform all of their activities and investments" to the rule "unless that period is extended by the Board."

But then came the additional guidance that in the meantime "banking entities should engage in good-faith planning efforts, appropriate for their activities and investments, to enable them to conform their activities and investments to the requirements."

Once the regulators have set a deadline, why do they need to require "good-faith planning efforts" to meet it? Either banks make the deadline or they don't. Are Fed governors trying to suggest that firms can fail to plan in good faith as defined by the Fed wise men, even if they end up meeting the deadline? Or does it mean the Fed wants to hedge on enforcement because it still doesn't know how narrow or wide its trading ban will be and doesn't want to force banks to meet a standard it might not propose?

Not surprisingly, banks have interpreted the letter to mean they have two years to comply. Sen. Carl Levin (D., Mich.), on the other hand, says the Fed should start forcing changes immediately. But Mr. Levin and the other Congressional backers of Dodd-Frank have only themselves to blame if it's unclear when and what the banks must do.

This entire episode will strike many non-Washingtonians as ridiculous. How can anyone announce a credible deadline before announcing what it is that's required to happen by that date? But in the amazing era of Dodd-Frank and its unrealistic mandates, this is almost becoming standard operating procedure. At the Commodity Futures Trading Commission, regulators began proposing a new set of rules for "swap dealers" before they had even decided what a swap is. Or what a dealer is.

It's true that the prospect of some kind of Volcker rule has reduced trading activity at the big banks and led to the closure of numerous Wall Street desks dedicated to proprietary trading. The traders are moving to less regulated hedge funds and private-equity shops. But looming higher capital rules could have the same effect by restricting the leverage that has fed the trading operations at giant banks. Higher capital rules can also be applied with more uniformity and transparency.

The danger of Volcker, as rendered by Washington and as suggested in the Fed's recent letter, is the danger that exists throughout Dodd-Frank. It is the taxpayer danger that results when regulators prone to capture by the industries they regulate are vested with huge authority and discretion to favor some activities while disadvantaging others, and to help some firms while harming others.

Even though this isn't the season of Festivus, six big-bank CEOs recently sat down with Fed Governor Daniel Tarullo for an airing of industry grievances. It's just one of thousands of meetings across the financial landscape as the regulators and regulated maintain their Dodd-Frank embrace. The result will not be regulatory clarity.

Seeing the confusion triggered by a Fed statement that was simply intended to announce a date, readers can imagine what will happen when the bureaucrats finally decide how to define, for example, the difference between buying securities to fill client orders and buying them to make a profit. In the fog of uncertainty, the next great Wall Street risks will likely arise, and history suggests that regulators will be the last to spot them.