How the Volcker Rule Would Affect Banks

In late January President Obama introduced new bank rules to be tacked on to the broader bank reform package that his administration proposed last summer. The brainchild of Paul Volcker, former chair of the Federal Reserve, the new rules collectively were quickly dubbed the "Volcker Rule."

"We have to enact commonsense reforms that will protect American taxpayers and the American economy from future crises," the president said during a press conference announcing the new rules. "While the financial system is far stronger today than it was one year ago, it's still operating under the same rules that led to its near-collapse."

Essentially, the Volcker Rule would pohibit retail banks from conducting proprietary trading and limit the size of the largest banks. But while there seems to be general agreement that financial reform is needed, at a Senate banking committee hearing in early February, senators took issue with the Volcker Rule.

Senator Christopher Dodd (D-Conn.), chairman of the Senate Banking Committee, objected to the 11th-hour nature of the new rules, a potential obstacle to his desire to pass financial reform before he retires this year. And Sen. Mike Johanns (R-Neb.) pointed out that the Volcker Rule would not have prevented the financial crises at AIG or Lehman Brothers because it only applies to banks. Volcker responded that his rules won't solve every problem, but in conjunction with the broader reform proposal, they would help prevent future crises.

Sen. Mike Crapo (R-Idaho) said it would be important to define proprietary trading. Volcker's reply: "Bankers know what proprietary trading is and what it is not, and don't let them tell you any different."

Other observers also disagree with basic tenets of the Volcker Rule. "Volcker is saying that if you return the banking system to the way it was before 1999, when he was head of the Fed and we didn't have these problems, that would prevent failures," says Lawrence Kaplan, attorney at Washington, D.C.-based law firm Paul Hastings. "But so could stronger regulation and capital requirements, the traditional ways regulators deal with risk. Paul Volcker is brilliant, but he comes from an earlier era; the world has changed since then."

How the Volker Rule Would Affect Banks

In case the Volcker Rule is enacted by Congress, here's how they might affect banks.

• Which banks would be affected by the Volcker Rule?
  In the Senate hearing, Volcker said that only four or five U.S. banks and "perhaps a couple of dozen worldwide" are engaged in the controversial proprietary trading activities.
• How would banks get rid of their proprietary trading businesses and affiliations with hedge funds and private equity funds?
  "Chances are they could spin them off," Paul Hastings' Kaplan suggests, in some cases to partners. "But the unwinding will be challenging. This is like using a meat cleaver when you need a scalpel. There are a lot of consequences; you can't just say stop."
• How big is too big?
  "That's a great question," says Kaplan. "The answer is probably, 'You know it when you see it.' If I were Jamie Dimon at JPMorgan Chase, I would say, 'I rescued Washington Mutual and Bear Stearns -- I only got big because you made me.'"

Matthew Cohn, leader of Capco's banking group, says he has heard that the Obama administration would like to reduce any bank's market share of deposits to no more than 10 percent. "The idea seems to be, we don't want to have too much concentrated in a single institution," he relates. "I don't think they're saying the large banks have to unwind their existing positions. But I think they'll say we're not going to let you get bigger through acquisition."

The Volker Rules

RULE #1: Banks would no longer be permitted to own, invest in or sponsor hedge funds, private equity funds or proprietary trading operations for their own profit unrelated to serving their customers. "These kinds of trading operations can create enormous and costly risks, endangering the entire bank if things go wrong," President Obama said during a press conference announcing the reforms. "We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest. And we cannot accept a system in which shareholders make money on these operations if the bank wins, but taxpayers foot the bill if the bank loses."

RULE #2: Banks cannot get too big (to fail). "There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank," the president said, possibly referring to a rule established in 1984 that forbids any bank from holding more than 30 percent of national deposits.