DAVID E. MCCLEAN, PHD

November 11, 2010

One of the new bank restrictions that will soon be imposed by the Obama Administration comes in the form of what is called the "Volcker Rule," named for former Fed chairman, Paul Volcker. The Volcker Rule is part of the new Dodd-Frank law that was enacted earlier this year to reform various aspects of the financial services industry.

Here's what the Volcker Rule does.

The Volcker Rule prevents banks from engaging in what is known on Wall Street as "proprietary trading." Propriety trading simply means buying and selling financial instruments of one kind or another using the bank's own money, for the bank's own account/profit.

Your eyes may have already begun to glaze over, but here is why you should take heed.

As I write, banks and securities firms are feverishly trying to find ways to soften the blow of the new rule, by any means necessary. Why? Because some serious profits come from proprietary trading, and those profits are about to go away. Also, the Volcker Rule prohibits the use of affiliates to engage in proprietary trading, so that these banks won't be able to do indirectly what they can't do directly. The reason for the Volcker Rule is that proprietary trading is risky, and is best left to Wall Street firms whose raison d’ętre is assuming such risks (these firms are known as "broker-dealers" - which are sometimes also called investment "banks," but they are not banks in the traditional sense -  institutions that take deposits and make loans). Since banks are in the business of taking deposits and lending money, which is critical to the day to day operation of the entire economy, the Volcker Rule is the result of seeing what happens when banks stray too far from those core businesses, and wind up causing great harm to the financial system. As we have seen, banks can go - and have gone, in many cases - belly up because of huge losses from their proprietary trading activities. These losses can also happen when banks take longer-term ownership in certain types of highly risky and highly leveraged (indebted) investment vehicles, such as hedge funds. The Dodd-Frank law clamps down on that, too.

Quite expectedly, the banks are fighting back. Since they can't change the Volcker Rule (which is really a statute, not a rule), they are trying to impact the actual rule-making processes among the regulators that oversee the banks. As the old Bus Boys song goes, "the boys are back in town," and the "boys" are fighting like hell to make sure that any such rules are so watered-down  that the banks can keep right on trading. The banks want to return to the "Halcyon days" prior to the credit crisis and the housing market collapse, as though they can now be trusted to do what they failed to do in the past - apply good sense and wisdom to their proprietary trading activities. We can't let them.

One of the things that the banks are arguing is that, well, it is hard to tell the difference between a "proprietary trade" and a trade done for, say, you, as a customer. This is an interesting, if disingenuous, argument. The accounting departments of banks have always been able to determine when revenue is coming from trades for other people (called "agency" trades because the banks are acting as agent for someone else) and trades done for "the house" (proprietary trades). The banks, and their cohorts in the securities industry (those broker-dealers I mentioned, above, who do lots and lots of trading with the banks, and who want to keep doing so - because it makes them rich, too), want the regulators and Congress to believe that the difference between a proprietary trade and an agency trade is so fuzzy that, well, gosh, who can tell the difference? This is, of course, nonsense. If the banks get away with it, it will be business as usual in a very, very big way. It will be as though the trauma of the past few years never happened. But it did happen, and it almost destroyed the financial system. It was not all the fault of banks' proprietary trading and risky investments, but much of it was.

We can't let it happen again. While it may be that the Volcker Rule was too severe on the issue of bank trading, it is largely on point. How can your voice be heard on this seemingly arcane but critical issue? I will let you know in a few days. In the meantime, read this instructive piece in the New York Times.