Paul Volcker

The Volcker Rule has been formally approved by the FDIC, Federal Reserve and SEC. The Volcker Rule, named after former Fed Chairman and advocate Paul Volcker, was passed as part of the Dodd-Frank reform act in 2010 and is meant to prevent or limit large Wall Street banks from proprietary trading – trading on their own account.

Proprietary trading in risky markets is believed to have contributed to the 2008 financial meltdown and subsequent government bailout. The Volcker rule, in theory, tells Wall Street banks they can either be risky investment banks or safe protected banks, but not both. This would, again in theory, prevent the need for future bailouts.

The Federal Deposit Insurance Corp., Federal Reserve Board and Securities and Exchange Commission on Tuesday approved the Volcker rule, set to usher in a new era of tough oversight that drills to the core of Wall Street’s profitable markets and trading businesses.

The so-called Volcker rule will put in place new hurdles for banks that buy and sell securities on behalf of clients, known as market making, and will restrict compensation arrangements that encourage risky trading.

The rule itself is about 71 pages long with an 889 page preamble. The banks have until July 21, 2015 to be in full compliance with the rule.

It is also worth nothing this not a return to Glass-Steagall. Commercial and investment banks can remain merged just with tighter restrictions. The big loophole remains due to the lack of definition as to what is “speculating” and what is “hedging.” The Volcker rule is meant to highly restrict speculating but allows for hedging. The difference between the two is often hard to find, especially for regulators who might be working on Wall Street later. The justification for a “hedge” relies on regulators accepting the Wall Street firms rationale.

However, if properly implemented the rule could pose serious problems for firms like Goldman Sachs that derive most of their income from speculating.

The storied investment bank gets a larger proportion of its revenue from the line item called fixed-income, currency and commodities trading, or FICC, than its rivals. And that sort of trading could be impacted by the Volcker Rule more than any other…

FICC is hugely important for those banks, but most of all for Goldman. The bank has garnered 27% of its total revenue from FICC so far this year, making FICC its biggest business. And while that makes Goldman highly dependent on FICC, that’s actually an improvement, as far as diversification goes, compared to the past few years.

Speculating in bonds, commodities, and currencies is hardly a hedge. If Goldman wants to rely on government protection, as it has so far, they will need to change their business model. That is, if they can’t win over regulators to their way of thinking somehow.

The saga of the Volcker rule is far from over.

Photo by Federal Reserve under public domain.