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Trimming the hedging of America’s banks

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Enacted in 2010 as part of the Dodd-Frank financial regulation law, the Volcker Rule had a clear purpose: Prevent large, federally insured banks from speculating in the financial markets. Named for its leading advocate, former Federal Reserve chairman Paul A. Volcker, the rule was supposed to help reestablish a line between commercial banks, which would collect deposits and make loans, and hedge funds, private equity companies and investment banks, which would take risks without any federal safety net. Keeping banks out of the speculation business would eliminate a source of system instability and taxpayer risk.

The problem has been how to distinguish speculative activities, known as "proprietary trading," from activities Congress wants to permit, such as "market-making," in which banks buy and sell securities as a service to clients, and hedging, in which banks purchase securities to offset risks elsewhere in their holdings. These line-drawing exercises — and others — occupied five federal agencies from the time Dodd-Frank passed until Tuesday, when the agencies finally approved a regulation to implement the Volcker Rule.

No one would confuse the 71-page opus, and its 800-plus pages of explanatory text, with the clear, crisp ban on proprietary trading that Mr. Volcker first articulated. But on the whole, it is faithful to Mr. Volcker’s vision and likely to promote financial stability if well-administered. It defines market-making narrowly, linking it to demonstrated past client demand for such transactions, and it discourages banks from compensating employees according to trading gains. It also requires top management to vouch, in writing, for their compliance efforts.

On hedging, the rule is tougher than many expected, ruling out transactions that are not necessitated by a "specific, identifiable risk." This would appear to eliminate broader "portfolio risk" hedging of the kind that earned JPMorgan Chase a $6-billion loss on the notorious trades known as London Whale. Indeed, the fiasco was a turning point in the Volcker Rule process, leaving regulators much more skeptical of the banks’ arguments. Or, as Federal Reserve Governor Daniel K. Tarullo put it Tuesday, the London Whale loss "allowed staff to test the procedural and substantive requirements of the proposed rule against a real-world example of what should not happen in a banking organization."

As it happens, we are already living in a partially post-Volcker Rule world. The nation’s largest banks have been getting out of the proprietary-trading business in anticipation of the final document. But since they presumably abandoned the most clearly impermissible activities first, regulators could well be left to face the murkiest gray areas when the rule takes full effect in July 2015.

Mr. Tarullo alluded to these coming judgment calls when he noted that "a specific trade may be either permissible or impermissible depending on the context and circumstances within which that trade is made." As he also suggested, the challenge for regulators will be to conduct that case-by-case analysis without descending into arbitrariness. Ultimately, inconsistent regulators would offer the public no more protection than profit-seeking traders.

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