Regulators Vote to Approve Volcker Rule

Federal regulators voted on Tuesday to approve a rule that strikes at the heart of Wall Street risk-taking, a moment that punctuates three years of internal squabbling and bank lobbying over an effort to reshape the financial landscape.

The so-called Volcker Rule, a centerpiece of the Dodd-Frank financial overhaul law and a symbol of the Obama administration’s efforts to rein in risk-taking after the financial crisis, received approval from one of the five regulatory agencies writing the rule, the Federal Deposit Insurance Corporation. The other four agencies â€" the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Comptroller of the Currency - plan to approve the rule by the end of Tuesday. The trading commission, though, is voting in private because of inclement weather in the Washington area.

The votes on the rule represent a turning point in financial reform. Although it is only one of 400 rules under Dodd-Frank â€" and nearly two-thirds of the regulations remain unfinished - the Volcker Rule became synonymous with the law itself. And with regulators easing other rules under Dodd-Frank, the Volcker Rule became a barometer for the overall strength of the law.

In some crucial areas, regulators adopted a harder line than Wall Street had hoped. Under the rule, which bars banks from trading for their own gain and limits their ability to invest in hedge funds, the regulation includes new wording aimed at the sort of risk-taking responsible for a $6 billion trading loss at JPMorgan Chase last year. The rule also forces banks to shape compensation packages so that they do not reward “prohibited proprietary trading.”

In addition, it requires chief executives to attest to regulators every year that the bank “has in place processes to establish, maintain, enforce, review, test and modify the compliance program,” a provision that did not appear in an October 2011 draft of the rule.

But the rule, which aims to draw a line between everyday banking and risky Wall Street activities, has its limits. For example, the regulation leaves it largely up to the banks to monitor their own trading. Some critics of Wall Street also wanted chief executives to attest that their bank was actually in compliance with the rule, not just that it was taking steps to comply.

And in another concession to Wall Street, regulators will delay the effective date of the rule to July 2015. Until then, bank lawyers are expected to scour the rule for loopholes and to consider bringing lawsuits against the regulators.

The votes, which come more than a year after Congress required the agencies to finalize the Volcker Rule, offer the financial industry some long-sought clarity. Until recent days, regulators appeared unlikely to meet the recommendation of Treasury Secretary Jacob J. Lew, who urged the agencies to complete the rule this year.

“For a time, I had begun to think that the Volcker Rule was destined to become the Jarndyce v. Jarndyce of administrative rule-making,” said Daniel K. Tarullo, the Federal Reserve governor who led much of the negotiating on behalf of the agency, referring to the long-running litigation at the center of the Charles Dickens novel “Bleak House.” “But I think the text before us is an improvement, both normatively and technically, on the proposed rule issued in October 2011.”

Ben S. Bernanke, the Fed chairman, also nodded to the delay, noting that “getting to this vote has taken longer than we would have liked, but five agencies have had to work together to grapple with a large number of difficult issues and respond to extensive public comments.”

Even as the agencies approved the rule, which spans 71 pages and features a preamble of nearly 900 pages interpreting the rule, they were expected to be split along partisan lines, with Republicans opposing a rule they say might stifle economic growth.

Wall Street is reluctant to claim either victory or defeat. No banks or financial trade groups immediately commented on the rule.

But some lawyers predict a smooth transition. Already, most big banks have complied with large swaths of the rule, shutting down standalone proprietary trading desks. The banks are now planning to throw resources at new compliance manuals and training their traders to comply with the rule.

The rule traces to Paul A. Volcker, a former Fed chairman and adviser to President Obama, who championed a ban on banks trading for their own gain, a lucrative yet risky practice known as proprietary trading. Such a prohibition, Mr. Volcker argued, would curb risk-taking and avert future bailouts of Wall Street.

The idea gained traction as a politically viable alternative to legislation that would have restored Depression-era reforms that forced banks to spin off their turbulent Wall Street operations from their deposit-taking businesses. Ultimately, over the objection of Wall Street and most Republicans, Democratic lawmakers inserted the measure into Dodd-Frank in 2010.

The rule, a draft of which regulators proposed in October 2011, stood out for its complexity. And regulators conceded on Tuesday that such complexity remained in the final draft.

“Many of us - myself included - had hoped for a final rule substantially more streamlined than the 2011 proposal,” Mr. Tarullo said. “I think we need to acknowledge that it has been only modestly simplified.”

While outlawing proprietary trading, the rule allows banks to continue buying stocks and bonds for their clients â€" a process known as market-making - and to place trades that are meant to hedge their risks.

But the line between proprietary trading and these more legitimate practices is blurry at best.

Banks could build a proprietary position in shares of General Electric under the guise of market-making, for example, contending that at some point clients might buy the shares. JPMorgan’s $6 billion trading blowup last year also underscored how banks can classify a proprietary bet as a hedge.

Wall Street seized on the gray area, presenting a united front against the rule to argue that it might undercut a bank’s ability to buy and sell investments on behalf of clients. The financial industry voiced its discontent in scores of comment letters and meetings with regulators, with executives for Morgan Stanley writing to complain that “the list of undesirable consequences is long and troublesome.”

The final draft, a product of compromise among the regulators, became tougher in many ways.

To address the sort of risk-taking that fueled JPMorgan’s trading blowup, which became known as the “London Whale” â€" the bank contended it was trading to hedge its broader risks, but in fact it built a sprawling speculative position that spun out of control â€" the rule will require banks to identify the exact risk that is being hedged. The risks, the rule said, must be “specific, identifiable” rather than theoretical and broad.

The rule also requires banks to conduct a “correlation analysis” as well as “independent testing” to ensure that the trades used for hedging “may reasonably be expected to demonstrably reduce” the risks.

To further prevent banks from masking proprietary trading as a hedge, the rule requires banks to conduct an “ongoing recalibration of the hedging activity by the banking entity to ensure” that the trading is “not prohibited proprietary trading.”

Some critics of Wall Street praised the final rule.

“The rule recognizes that compliance must be robust, that C.E.O.s are responsible for ensuring a compliance program that works, that compensation must be limited, and that banned proprietary trading cannot legally be disguised, as market making, risk mitigating hedging or otherwise,” Dennis Kelleher, the head of Better Markets, an advocacy group. “Those requirements will not end all gambling activities on Wall Street, but should limit them and reduce the risk to Main Street,” Mr. Kelleher said.

The exemption for market-making may still be vulnerable to evasion. Under the rule, banks can build up positions to meet “the reasonably expected near-term demands of clients, customers or counterparties.” Banks and regulators may clash over what is “reasonably expected,” and the rule leaves it largely up to banks to monitor their own trading.

The rule also allows banks to do proprietary trades in bonds issued by governments. United States banks can make bets with Treasury securiteis and even municipal bonds. In a significant concession, the Volcker Rule allows the foreign affiliates of United States banks to trade in bonds issued by foreign governments.

In the coming months, Wall Street lawyers and business trade groups will consider whether to challenge the Volcker Rule in court, people briefed on the matter said. The groups, including the United States Chamber of Commerce, are hinting that they could use litigation to either undercut or clarify the rule.

Regulators said they would keep an eye on the activity.

“This rule must not be static,” said Bart Chilton, a Democratic commissioner at the C.F.T.C. “Regulators need to continue to monitor what is taking place. We need our regulatory eyes in the sky but also to look around the corner for what’s coming next, and be nimble and quick, to ensure that what we do today holds up and that the high roller’s room isn’t re-opened.”