How Will the Volcker Rule Stand Up Against the Armies of Wall Street?

When the long-awaited Volcker Rule finally emerged last week, the outside world took out its magnifying glass. The advance buzz had said it would be "tougher than expected." But soon enough, critics were poring over the text, spotting weaknesses, comparing notes, and even, in a few cases, calling it things like "Washington's latest bonanza for lawyers and lobbyists" or the "one of the great pieces of Swiss cheese in regulatory history."

The grounds for concern are real. This was a committee product, shaped by 22 principal negotiators representing five agencies, dogged every step of the way by powerful and determined Wall Street lobbyists. At the same time, it is worth a cheer that the rule got done at all, thanks to the vigilance of advocates and recent prodding by Treasury Secretary Jacob Lew, among other things. Too often, rules opposed by industry can languish indefinitely, sometimes even for decades. We should also be grateful that those 22 principals included supporters of a strong rule who were able to insist on important improvements as the process came down to the wire.

While the final rule includes a number of gray areas, its clear intent is to curtail the ability of banks to use their government guarantees and inside advantages to engage in speculative activities for their own gain. If properly implemented – a big if, to be sure – the Volcker Rule could make it much harder for banks to gamble with taxpayer-backed funds, significantly reducing their ability to extract wealth from other areas of the economy, foment asset bubbles and leave the rest of us on the hook for the bets that go wrong.

The old regime of financial regulation – the one that slowly came apart in the decades leading up to the 2008 meltdown – dealt with this problem in a cleaner way. Under the Banking Act of 1933, also known as the Glass-Steagall Act, commercial banks, which take deposits and make loans, were ordered to get out of the business of investment banks, which package and trade securities. End of story.

Now, as then, a strong case can be made for keeping these lines of business separate; indeed, a worthy bill entitled the 21st Century Glass-Steagall Act was recently introduced by Sens. John McCain, R-Ariz., Elizabeth Warren, D-Mass., Maria Cantwell, D-Ore., and Angus King, I-Maine. But when the Dodd-Frank financial reform law was being hashed out in 2009 and 2010, Congress was not ready to take that step.

In fact, when the deliberations got underway, it looked like Dodd-Frank might do little or nothing to directly restrict securities speculation by banks. The Volcker Rule, proposed by former fed chairman Paul Volcker, made its way into the legislation only after a series of devastating revelations of dishonest securities marketing by banks which had abused the trust of their clients. Even then, success came only after a major battle led by Sens. Jeff Merkely, D-Ore., and Carl Levin, D-Mich., with a broad coalition of financial reform groups standing behind them.

By its nature, the Volcker Rule was bound to put a heavy burden of responsibility on the regulators and their decisions. That's because the securities trading activities that the rule allows – hedging, underwriting, and so-called market-making – tread close to (and could easily become a cover for) the "proprietary trading" that it prohibits. It's also because the big banks command an army of highly paid and skilled lawyers who stand ready to turn the smallest ambiguity into a "London Whale-size" loophole.

Indeed, they are at it already. The law firm of Bingham McCutchen held a Volcker rule "boot camp" for its attorneys last week, according to Bloomberg. At another big firm, Jones Day, some 200 lawyers were said to be working overtime to "make sure we have our arms around the content of the rule," as one partner explained.

The regulators will have to stand up to that army, not just once or twice but for the long haul, trade-by-trade and deal-by-deal. They'll have to be willing to incur the industry's wrath and withstand the inevitable predictions of economic Armageddon. Modern history abounds with instances in which regulators have buckled before this kind of assault.

But if we look back, we can also find cases in which regulation has worked to make markets safer and more credible. From the 1930s into the 1980s, for example, U.S. banking and securities regulation worked remarkably well, restoring the credibility of an industry that had sold the country down the river in the 1920s, and laying the groundwork for nearly half a century of unprecedented financial stability.

In its final form, the Volcker Rule gives regulators a usable set of tools for making sure that banks limit their speculative activities. And some of the agency heads who signed off on the rule were refreshingly quick to acknowledge the importance of vigorous follow-though.

"The [Office of the Comptroller of the Currency] will be especially vigilant in developing a robust examination and enforcement program that ensures our largest institutions will remain compliant," said Comptroller of the Currency Thomas J. Curry, speaking for an agency known as an industry pushover in the pre-crisis years.

Much the same point was made by Ben Bernanke of the Fed, which has its own shaky history to live down. "The ultimate effectiveness of the rule," Bernanke said, "will depend importantly on supervisors, who need to find appropriate balance, while providing feedback to the board on how the rule works in practice."

Regulatory feedback will be crucial – feedback not only to agency heads and directors, but to the wider world as well. The complexity of this rule makes transparency especially important. To keep the process of enforcement from disappearing into closed-door arguments between bank lawyers and bank overseers, the public must be able to see exactly how bank behavior has changed or not changed, and what the regulators are doing about it. That will require hard data on bank trading practices. One prominent economist has called on regulators to establish a public 'audit trail' that would release full trading data on a delayed basis. That's the kind of information that would truly make it possible to tell how well the Volcker Rule is working.

There was considerable public interest in the writing of the rule, and it was encouraging to see many footnotes in the official discussion citing the opinions of the handful of public-interest organizations that weighed in (along with many banks and bank-connected law firms). Traditionally, bank regulators have been anything but champions of transparency; and since the Volcker Rule's release, they have said little about how or even whether they propose to keep the public posted on the progress of implementation.

To hold the industry accountable, the regulators will need to move beyond the closed-door approach that has been their comfort zone. To hold banks and regulators alike accountable, the rest of us will have to go right on pushing on those doors.

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