In English - Why The Volcker Rule Might Actually Change Wall Street
It's a rule that, at its heart, is supposed to stop Wall Street from making massive, risky bets with money that should be flowing through the global economy, making the wheels turn.
Today, regulators are set to approve the final version of the rule, and it could actually change Wall Street where it really matters - its culture.
From the beginning, Volcker was hated. Bankers fought it, regulators slogged through it, and its name-sake - former Federal Reserve Chair Paul Volcker - maintained that it would only go as far as absolutely necessary. Now that the rules are here, here's what they actually mean.
Banks will have to set up internal compliance programs and monitor their trading. What that's supposed to prevent is another massive 'London Whale' $6.2 billion trading blow up, like the one at JP Morgan last year.
What happened was, a few traders were working on a portfolio of the bank's own money, and for months they hid losses from their superiors as the loss grew and grew.
When all of this was discovered (at around the $2 billion mark), JP Morgan executives said that the portfolio was meant to "hedge", or counter risk, in the bank's other activities.
Regardless it violated a Wall Street rule, it lost money. So the Volcker Rule addresses portfolio hedging. It allows it but only in the event that the hedge is "designed to reduce, and demonstrably reduces or significantly mitigates, specific, identifiable risks of individual or aggregated positions of the banking entity."
This will have to be clear in trading reports.
Banks will also have limits on securities they can hold in order to engage in market making (procuring securities quickly) for their clients. The exception to this limit will be on sovereign bonds.
Remember the Euro crisis? That's what this exemption speaks to. In the event that a sovereign country is about to go down, banks will be able to quickly buy and sell their bonds and keep the market liquid. This was a huge concern for banks, countries and regulators.
Banks will also be prohibited from owning more than 3% of hedge funds or private equity firms that do not have these restrictions.
Now, the glue the holds all this together is what the Volcker rule does to compensation - how banks make it rain on bankers.
This is what could change culture, because the main reason why Wall Street has such a "hard time being ethical" (in the words of one former banker) is because it is a culture that handsomely rewards risk - and risk sometimes means stepping over the line.
The Volcker Rules prohibits banks operating in the U.S. (so this goes for foreign banks to) from compensating traders for risky behavior. As Ben Bernanke said aptly, the success of this rule will depend on bank supervisors, but taking the reward from risk could very well make an impact on Wall Street's culture.
As yet, it is unknown how much money this could cost individual banks. Some say billions. What is known, though, is that this rule wasn't written to save their businesses. It was written to protect the larger system, and to mitigate the cost of risk to the U.S. taxpayer. The business of Wall Street will have to take a back seat to that.
The rule goes into effect on April 1st, 2014.