What the New Volcker Rule Means in Plain English

Photo (cc) by HarvardEthics

If you want to take your money to the track and bet it all on the ponies, that’s your business. But if taxpayers are going to have to bail you out when you lose it all, your business becomes ours.

That’s the simple logic behind the Volcker Rule, issued Tuesday morning.

The specific regulations — named after former Federal Reserve Chairman Paul Volcker — are a complex document detailing what federally insured banks can and can’t do with their money.

The idea behind the rule is to prevent banks from engaging in the type of risky investment behavior that helped take the world economy to the brink during the financial crisis and cost American taxpayers billions.

Here’s what the new rule does and doesn’t do.

No more proprietary trading

If you have some extra money lying around, you’re free to do anything you want with it, including taking it to the nearest casino or engaging in other types of risky behavior. Prior to the Volcker Rule, banks were free to do the same thing.

On Wall Street, this is known as proprietary or “prop” trading — investing the bank’s money to make more.

Last summer we got a textbook example of what can go wrong. A trading division in the London office of JPMorgan lost close to $6 billion. That loss didn’t take down the bank — it earned $21 billion in 2012 — but had the bank been smaller or the loss bigger, it could have, leaving taxpayers on the hook.

So the Volcker Rule now prohibits banks from prop trading, thus indirectly safeguarding public funds.

But there are plenty of exceptions

Never has the saying “For every rule, there’s an exception” been more appropriate.

The Volcker Rule is filled with exceptions that allow banks to continue certain types of trading. For example, hedging is still allowed. That’s making an investment designed to offset a potential loss from another investment.

For example, say JPMorgan lends $500 million to General Electric. It could buy a kind of insurance policy known as a “credit default swap” that would pay them back if GE can’t. Hedges like this make sense because it reduces the bank’s risk in the same way your home insurance reduces yours.

Banks are also still allowed to hold large amounts of stocks or bonds for customers or potential customers, something known as “market making.”

Some are arguing that these and other exceptions, along with vague wording within the rules, will remove some of the teeth in the Volcker Rule. Others say the regulations and paperwork required to follow them go too far.

No more rewarding risky behavior

Imagine having a job where making a risky bet could personally net you a $5 million bonus if you’re right, and cost you nothing more than your job if you’re wrong.

That’s the way banks have traditionally compensated investment traders. When JPMorgan traders lost their employer $6 billion, they lost their jobs, but that’s all they personally lost.

The Volcker Rule tries to reduce this risk by attempting to tie trader compensation to factors other than the profitability of a trade.

Will it hurt the banks?

No business likes the government looking over its shoulder, and banks are no exception. They’re also among the strongest lobbies in the country. So if you guessed they’ve been doing everything in their power to water down the Volcker Rule during the years it’s taken to create, you’re right.

One way to see if the implementation of the rule will hurt them is to look at the stocks of the big banks in the hours after the rule was made public. At the close of Tuesday trading, the overall market was down, but the stock of JPMorgan was up slightly, Citibank and Bank of America were down slightly, and Goldman Sachs and Morgan Stanley were up 1.4 percent.

Part of the reason the release of the Volcker Rule has had little effect on share prices is because most of it wasn’t a surprise and the banks have had years to prepare for it. In fact, the Volcker Rule merely puts in writing what most major banks long ago put into practice.

So, now that you know what it’s about, what do you think of the Volcker Rule? Is it an example of a regulation-happy government surpressing capitalism, or a much-needed consumer protection? Sound off below or on our Facebook page.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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