Drawing Bright Lines for Banks

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What began as a simple idea aimed at preventing banks from gambling with taxpayer money has become one of the most-delayed elements of the Dodd-Frank Act. Regulators are squabbling over how to get the wording right. They would do best to just get it done.

Known as the Volcker rule, after former Federal Reserve Chairman Paul Volcker, the legislation has a laudable goal: Ban commercial banks, which enjoy government subsidies in the form of federal deposit insurance and access to emergency loans from the Fed, from putting taxpayers at undue risk by engaging in short-term speculative trading.

Turning the law into an actionable rule has already taken more than three years. Authorities say it could take several months more. The difficulty arises mainly because the legislation makes exceptions for activities that aren’t speculation but can look like it. These include market making, in which a bank buys and sells securities on behalf of clients, and hedging, in which a bank takes positions designed to mitigate potential losses on its loans and other investments.

Regulators have gotten themselves into a tangle over drawing these distinctions. They’ve proposed a multitude of revenue, turnover and other measures -- 17 for market making alone -- without specifying how these numbers will be used to identify illegal activity.

This we’ll-tell-you-when-we-see-it approach satisfies nobody -- even if, as we have advocated, the measures are pared down to the few most relevant. Proponents of the rule worry that regulators, some perhaps hoping for future employment on Wall Street, will let banks do pretty much anything. Others opposed to the rule worry that banks will cut back on activity crucial to the smooth operation of markets, for fear that authorities will deem it illegal.

Some bright lines are needed, and they’re actually not that hard to draw. Consider profit and loss. Speculative traders try to generate large gains, and so often suffer large losses. Their income is volatile. Market makers, by contrast, expect to avoid volatility, aiming to generate steady revenue from the flow of client business. Hedgers seek to reduce volatility by definition.

Hence the bright line: The rule should say that positions held by a bank’s market-making operation, or in a book of hedged investments, shouldn’t exceed a certain level of volatility. That level might change depending on whether the trading is in stocks or distressed debt, but it would certainly be much lower than that of the broader market. If a bank crossed the line, it would bear the burden of proving that it wasn’t engaged in illegal speculation.

To strengthen this approach, the Volcker rule should also require that traders’ bonuses reward success in making markets or hedging against losses, rather than for scoring big gains incidental to those goals. For market making, the relevant measure might be client volume. For hedging, it might be loss mitigation, with the biggest bonuses going to those who show no profit (or loss) at all. The rule should also specify penalties for failure to comply, both for the traders and for the executives who manage them.

Would banks be able to hide proprietary trading within whatever limits regulators set? Probably, but the potential for punishment would at least act as a disincentive. Would this approach inhibit banks from making markets in more exotic or distressed securities, for fear of accidentally breaching the volatility limits? Possibly, but if such business would be profitable in the absence of a taxpayer backstop, non-bank financial firms will step in to do it.

The point of the Volcker rule is to deny public subsidy to bank speculation. It isn’t the strongest defense against unsafe banking -- that would be stricter capital requirements -- but it will help, and the sooner it happens, the better. A relatively simple rule, making relatively few demands on regulators’ discretion, isn’t hard to write. There’s no reason for further delay.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.