Making the Volcker Rule Work

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.”

The approval of the Volcker Rule, restricting proprietary trading and limiting other permissible investments for very large banks, is a major step forward. Almost exactly four years after the general idea was first proposed by Paul A. Volcker, the former chairman of the Federal Reserve, and nearly three and a half years after it was mandated as part of the Dodd-Frank Act, the regulators have finally managed to produce a rule.

This rule could be meaningful, and that’s why there has already been so much pushback from the big banks. Their main strategy so far - denial that there is a problem to be addressed - has failed completely. Their legal challenges are also unlikely to succeed. The main issue now is whether the regulators force enough additional transparency so that it is possible to see the new ways that proprietary bets are hidden.

The Volcker Rule is intended to impact only the very largest banks - the material impact will be mostly on JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. The goal is simple and sensible. Given that these banks are supported by large implicit government backstops (e.g., from the Federal Reserve), they should be more careful in their activities and should not engage in large-scale bets that have the potential to cause insolvency for them and disruption for the rest of the global financial system.

These companies could choose to become smaller, with the constituent pieces operating under fewer restrictions. But their managements want to stay big, so they should face additional constraints.

The first pushback strategy - and the main focus of big bank efforts - is to deny that the Volcker Rule is needed at all. This line has been pushed hard over the last four years, including at a Senate hearing in February 2010.

Barry Zubrow, then chief risk officer at JPMorgan Chase, testified that the Volcker Rule was not needed, as risk controls in big banks were sufficient to the task. (I also testified at the hearing, in favor of the rule.) The extent to which JPMorgan Chase subsequently managed its own risks - including proprietary trading-type activities run out of its chief investment office - has been called into question. Mr. Zubrow retired at the end of 2012, telling his colleagues, “We have learned from the mistakes of our recent trading losses.€

I hope that is true, but it seems unlikely, because the name of the game for very large banks is leverage, i.e., taking big bets using a lot of borrowed money and very little equity. This is how to increase your return on equity, unadjusted for risk, which is what financial analysts (and the related news coverage) focus on. Most regulators now have this point much more clearly in their minds.

At the same time, Mr. Zubrow and others asserted that the introduction of any kind of Volcker Rule would have a big negative effect on financial markets and the economy. But as the passage of the rule approached, financial markets took that news completely in stride. Yes, we have lower employment levels than we would like, but that’s primarily because of the large financial crisis since the Great Depression, brought on by crazy risk-taking (for example, at Citigroup).

The conceptual fight against the Volcker Rule has been lost by the big banks, at least in part because of the London Whale losses overseen by Mr. Zubrow and his colleagues - but also because enough regulators have finally wised up to how the big banks really operate and why that can damage the real economy.

Treasury Secretary Jack Lew also deserves credit for pushing the rule toward the finish line and for insisting that top management be held accountable for whether companies comply with the law.

The second pushback strategy is legal - to bring one or more cases through the courts that will challenge key aspects of the Volcker Rule. Eugene Scalia, the son of Justice Antonin Scalia of the Supreme Court, has had some success with this strategy on other financial regulatory matters.

But as Barney Frank points out, the new Senate rules mean that we should expect confirmation of three new judges on the United States Court of Appeals for the District of Columbia Circuit, which is where the Volcker Rule would need to be challenged in the first instance. The chances of a successful legal case have therefore receded, although what happens when and if such a matter reaches the Supreme Court remains unclear.

The third strategy is to find new ways to hide the essence of proprietary trading - and this is an important open issue. Will there be enough disclosure and observable behavior for either the regulators or people on the outside to see whether the spirit of the Volcker Rule is being followed? For example, how exactly will traders be compensated and how much of this will be disclosed? Will data be available on trading activities, allowing independent researchers to look for patterns that might otherwise elude officials?

The Volcker Rule could be a major contribution to financial stability. Or it could still flop. The devil now is in the details of implementation and compliance - and how much of this becomes public information and with what time lag.