Getting the Volcker Rule Done

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

Mike Segar/Reuters Paul Volcker, former chairman of the Federal Reserve, has pressed forcefully for curbs on the biggest banks.

December is deadline time for one of the most important unfinished pieces of businesses from the Dodd-Frank financial reform legislation: the Volcker Rule. Based on an important intervention by Paul A. Volcker, the former chairman of the Board of Governors of the Federal Reserve System, in late 2009, the “rule,” whose legal intent is enshrined in Dodd-Frank, is simple - end proprietary trading by very large banks.

“Proprietary trading” is the business of betting, using the bank’s own funds, on the direction of markets. When these bets go well, traders and executives are very well paid through bonuses and other mechanisms. But when even a few mega-bets go badly (think mortgage-backed securities), there is a big potential downside risk to the economy, including damage to the bank’s ability to conduct all its ordinary activities (such as making loans to the non-financial sector).

The rule takes aim at the five largest complex financial companies, which have an implicit government backstop as well as insurance from the Federal Deposit Insurance Corporation for their retail deposits. This arrangement presumably encourages reckless risk-taking, including proprietary trading.

The big bank lobby has been fighting hard against any version of the Volcker Rule since it was first proposed. They have lost some important battles but remain determined to make one last-ditch stand, focusing on the argument that the rule should be further delayed. But delay in this kind of situation rarely leads to a better or stronger regulation.

It’s time to get the Volcker Rule done properly - and that means in line with what Mr. Volcker originally proposed and what the Democratic senators Jeff Merkley of Oregon and Carl Levin of Michigan put into legislative language.

(Mr. Volcker and I both take part in the Systemic Risk Council, founded and headed by Sheila Bair, former chairwoman of the Federal Deposit Insurance Corporation. The views expressed here are mine alone.)

There are three arguments still put forward by big banks and their advocates.

First, they assert that the rule is not needed, because proprietary trading was not a major cause of the crisis of 2007-8.

This point is irrelevant; we should always worry about what may happen in the future, not what happened in the past. It is also wrong. Remember, too, that the losses at Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and UBS were in no small due to forms of proprietary trading; Citigroup also springs to mind. I testified to the Senate Banking Committee in early 2010 in favor of the rule; John Reed, the former chief executive of Citigroup, was on the same side. We were opposed by the chief risk officer of JPMorgan Chase, among others.

Subsequently, JPMorgan Chase suffered big losses in a proprietary bet that has become known as the London Whale.

That these trades did not bring down JPMorgan Chase is not reassuring. Those losses and the way they were misunderstood or misrepresented by management are like a canary in the coal mine - telling you there is trouble ahead. When the canary dies from gas poisoning, the smart response is not, “Well, only the canary is dead, so let’s carry on with what we are doing.”

Second, some big bank advocates contend that they should be allowed so-called “macro hedging” or “portfolio hedging.” This is a dangerous idea, because in effect they are asking for the right to do any trade they want and - ex post - assert this is hedging for some part of the portfolio.

A much better approach, and hopefully where we are headed, is to allow hedging only for specific, measurable risks. The hedges would need to be identified when the trade is done; presumably this is part of the risk control and management reporting already. (Properly defined, “hedging” refers to the practice of trying to offset the risk in one transaction by undertaking another transaction that should be negatively correlated - i.e., when the value of one trade or asset goes down, the value of its hedge goes up.)

Third is a vague but potentially dangerous argument that various forms of financial regulation should be delayed until we can more fully converge with the Europeans and their planned rules.

As Jeffrey Schott and I explained in a recent paper on the potential free trade agreement with Europe, any version of this would be a bad idea.

There are many theories for why the Volcker Rule has taken so long to enact, including intentionally slow work by the staff of the Federal Reserve Board, divisions among members of the Securities and Exchange Commission and pushback from Europeans.

None of this matters today. As Treasury Secretary Jacob J. Lew said in July, “We will not let the pursuit of international consistency force us to lower our standards.”

The goal should be to complete the existing pipeline of reforms and then assess properly where we are. Again, Mr. Lew got this right when he said, “If we get to the end of this year and we cannot, with an honest, straight face, say that we have ended too big to fail, we are going to have to look at other options.”

Everyone working on the Volcker Rule should be held accountable to this high but entirely reasonable standard. Then we can assess the extent to which the problem of some banks’ being too big to fail is still with us - and what we should do about it.