Volcker Rule Leaves Opening for More Bank Regulations

On Tuesday morning, the Federal Reserve and the Federal Deposit Insurance Corp. both voted unanimously to adopt the Volcker Rule, which would bar banks from proprietary trading and limit their ability to invest in hedge funds and private equity funds. But there is one problem with the rule that could lead to a great deal of uncertainty for the nation's largest banks.

Cease and desist
Since the financial crisis in 2008, regulators have been looking for a way to reduce the risky behaviors banks take in order to boost profits. Chief among those concerns was proprietary trading, where a bank would be investing its own funds in order to bring in gains. The practice is viewed as very risky and a main concern for those looking to avoid bailouts in the future.

With that in mind, the so-called Volcker Rule was drafted (and redrafted) over the past three years in order to rein in Wall Street banks. Though three other regulators -- the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Treasury Department's Office of the Comptroller of the Currency -- have to vote as well, there's little doubt that the Volcker Rule is here to stay.

Goldman Sachs (GS -1.00%) was viewed as one of the biggest targets for the Volcker Rule, with some worried that the bank wouldn't survive the new regulations. With more than a quarter of its total revenue coming from fixed-income trading, Goldman Sachs would be in deep trouble. But the rule provides some leniency, so investors have reversed their concerns about the bank, propping it up 1.23% on Tuesday after the voting.

Besides the ban on proprietary trading, the new rule also states that banks cannot simply participate in trades that are meant to be widespread hedges. Banks must now provide detailed information on the trades and their designed hedge benefits, as well as updates on the hedge's activity to regulators to ensure it is still permissible. This provision of the rule is most likely viewed as a way to avoid fiascoes like JPMorgan Chase's (JPM -1.14%) London Whale loss that totaled more than $6 billion and was the result of a portfolio hedge.

Needs a little context
Though the rule is stricter than what Wall Street's banks (and their lobbyists) would have liked, it does give some leeway for trading. Based on the provisions of the Volcker Rule, banks are allowed to continue buying and selling shares in order to allow them to facilitate trades for customers, known as market-making. Goldman Sachs is one of the New York Stock Exchange's designated market makers. The rule also allows securities underwriting and trading of U.S. government, state, and local bonds.

The real problem with the trading provisions is a degree of uncertainty, deftly highlighted by Federal Reserve Governor Daniel Tarullo (emphasis is mine):

Of course, the fundamental challenge is to distinguish between proprietary trading, on the one hand, and either market-making or hedging, on the other. The difficulty in doing so inheres in the fact that a specific trade may be either permissible or impermissible depending on the context and circumstances within which that trade is made.

There are guidelines within the Volcker Rule that will help both the banks and regulators determine the context for such trades, but the rule will need to be updated and expanded as new situations arise and trades become more complicated. For the nation's biggest banks, this lack of clarity will likely result in increased headaches in the form of higher scrutiny and less fluid operations as regulators monitor their activities. But the slightly foggy situation could allow a short-term advantage to any bank that finds a loophole -- at least until regulators take notice.

Gateway rule?
For investors, the current permutation of the Volcker Rule shouldn't be scaring you away from Wall Street's banks. Most have already closed their proprietary trading desks in anticipation of the new regulations, and the allowances for hedging, market-making, and underwriting will allow them to participate in many of the same transactions they were doing before. But one thing to keep in mind is the open-endedness of the rule that could lead to further regulations down the road. Though there are provisions within the rule that should help determine which trades are permissible and which are not, a certain amount of uncertainty will remain until the full scope of the law has been tested.