CAMBRIDGE, MA: 10 December 2014 – After some three years of regulatory wrangling, the Volcker Rule is set for its official unveiling. The nation's top banking oversight agencies have indicated they will vote this week to approve the directive, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

What's in the rule? Well, no one wants to say for certain. How will it work? Again, that's a detail that hasn't been disclosed.

About the best that can be said is that, if reports are correct, simplicity isn't one of the Volcker Rule's virtues: according to some news reports, the rule during the drafting process swelled to nearly 1,000 pages—or nearly half as long as the Dodd-Frank Act that mandated the creation of the rule.

Nevertheless, expectations are riding high on the Volcker Rule, which is perhaps appropriate since it's the namesake of former Fed Chairman Paul Volcker who, at six-foot-seven, was both literally and figuratively a towering figure in the history of banking regulation.

From an institutional corruption standpoint, the anticipated Tuesday vote by five agencies is an opportune time to take inventory of financial reform efforts since the crash that preceded the Great Recession. Has reform been shaped—for better or worse—by common symptoms of institutional corruption such as conflicts of interest, regulatory capture, and dependence between regulators and industry?

This institutional corruption inquiry will focus on three broad areas. One, did institutional corruption make a Volcker Rule necessary? Two, has institutional corruption delayed, or diluted, the rule that will be adopted? Finally, how might institutional corruption neutralize the Volcker Rule's effectiveness once it is officially the financial sector's rule of engagement?

In remarks last week, Treasury Secretary Jack Lew said the Volcker Rule will be a watershed moment in regulatory restructuring. "Rule-writers will soon put forward a tough Volcker Rule that I expect to be true to President Obama's vision and the statute's intent," Lew said at a program hosted by Pew Charitable Trusts. "The rule now before regulators for a vote is the product of much intensive work and analysis—and, needless to say, years of effort."

On that last point, there's little doubt. Dodd-Frank was passed in 2010, and the Volcker Rule was originally floated in 2011, but essentially withdrawn after an avalanche of industry outcry.


After The Fall

By way of background, it is helpful to start with a simple question: why is the Volcker Rule needed at all? The answer lies at the heart of the causes of the financial crisis, when markets plunged, banks collapsed and the economy fell into the steepest decline since the Great Depression.

Much of the carnage was rooted in Wall Street's slavish marketing of subprime mortgages, or home loans made to borrowers of unusually high credit risk. Numerous lawsuits—which resulted in some gigantic settlements—have alleged the investment risks were misrepresented and the deals were rife with conflicts of interest. For instance, the mortgages became the basis for residential mortgage-backed securities, or RMBS, that imploded when homeowners couldn't keep up with their payments and defaulted. Yet, at the same time institutions were selling securities to investors, they were allegedly privately placing bets that the securities were going to tank.

Beyond that, banks had attempted to hedge their risks by purchasing a form of insurance commonly called "credit default swaps," or CDS. CDS products are part of a financial category generally known as "derivatives."

Over time, a wild secondary market in derivatives developed as banks traded them "over the counter," or among themselves. The difficulty was that the underlying credit risks—and actual market value—were virtually impossible to determine. The trading itself morphed from a defensive strategy to a highly profitable playmaker. Regulators were unable to stop the clock, since derivatives were specifically exempted from oversight by the Commodity Futures Modernization Act of 2000.

The result was that, when everything collapsed, the entire financial industry was sitting on untold hundreds of billions of dollars in losses. Banks and some non-bank companies, like AIG, which had sold some $400 billion of CDS, had to be bailed out lest the financial system fail. The Wall Street bailouts remain highly controversial. As Nobel Laureate economist Joseph Stiglitz wrote in 2011: "The financial sector's inexcusable recklessness, given free rein by mindless deregulation, was the obvious precipitating factor of the crisis."

Note the language used by Stiglitz: the finance sector may have been guilty of "inexcusable recklessness," but that's not the same thing as calculated corruption. Rather, it suggests the culprit was institutional corruption—influences and conflicts, such as "mindless deregulation"—that are perfectly legal. So in that sense, it seems perfectly fair to argue that institutional corruption did make the Volcker Rule necessary.


Delay In Game

How is the Volcker Rule supposed to work? And more importantly, is institutional corruption at least part of the reason why it is years behind schedule?

The Volcker Rule would sharply limit "proprietary trading," where a bank trades in derivatives with its own capital. Banks could still engage in "market making," or trading in derivatives and similar products on behalf of clients. But in theory the Volcker Rule would sharply curtail their ability to place taxpayer-backed banking funds at risk.

From an institutional corruption standpoint, the problem isn't that there should be a line drawn, but rather where to draw it. Sometimes, for instance, a bank may need to take a position in a client's securities and act as an intermediary, particularly because derivatives often are illiquid. Is that market-making or a proprietary trade? And shouldn't banks be allowed to secure legitimate hedges against possible losses?
"In adopting the Volcker rule, Congress prohibited banking entities from proprietary trading while at the same time permitting banking entities to engage in certain activities, such as market making and risk mitigating hedging," Gary Gensler, the outgoing chairman of the Commodity Futures Trading Commission, which plays a central role in regulating derivatives, said last year. "One of the challenges in finalizing this rule is achieving these multiple objectives."

That challenge has created the years-long delay in writing and adopting the Volcker Rule. And during that delay the banking system was vulnerable to the kinds of losses that presaged the 2008 bailouts. A leading example is the $6 billion "London Whale" trading loss incurred by JPMorgan Chase.

That leads to the second point of our analysis: has institutional corruption played a role in the delay of the Volcker Rule? As Lawrence Lessig, Director of the Edmond J. Safra Center for Ethics, has written, institutional corruption is often the result of influences that cumulatively create an economy of influence that ultimately doesn't serve the public interest.

Rarely has a piece of legislation been subject to more influences than the Volcker Rule. To begin with, five regulatory agencies had to agree to terms: the Securities and Exchange Commission, the U.S. Commodity Futures Trading Commission, the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. Each agency has its own constituencies and its own policy goals. And the organizations aren't known, generally, for always acting collegially. The Fed and the OCC are reportedly leaning toward a lenient rule for banks, while the CFTC, at least under Gensler, who is soon leaving, has advocated for a stricter standard.

A further influence has been the banking industry, which has lobbied relentlessly as the Volcker Rule was shaped. (The so-called FIRE sector, for finance, insurance, and real estate, spent an estimated $488 million on lobbying in 2012, according to opensecrets.org, and $358 million as of Oct. 31 of this year.)

A 298-page draft Volcker Rule in 2011 drew a withering 18,000 comment letters, some from entities such as the Red Lobster restaurant chain, which said its concerns were that strict regulations could sap economic vitality and therefore reduce its business.

Even after all these years, some powerful business institutions maintain there's no rush. The "process to date has created a 'black box' of rule writing that could result in an unbridled exercise of regulatory power that can harm the economy," David Hirschmann, president of the Center for Capital Markets Competitiveness, formed by the U.S. Chamber of Commerce, wrote in a letter to regulators late last month. He added: "Therefore, we once again urge the Agencies to re-propose the Volcker Rule."

In that context, it's worth asking: at what point does a perpetual delay in policy become a policy? And in this particular case, does it serve the public interest or, rather, the economy of influence that is producing the delay?

Malcolm Salter, Senior Faculty Advisor to the Edmond J. Safra Center for Ethics and Harvard's James J. Hill Professor of Business Administration, Emeritus, refers to this type of problem as gaming. "It is one of the most corrosive forms of institutional corruption in business," Salter wrote in a 2010 working paper. Institutional corruption, he added, "refers to company-sanctioned behavior and relationships that may be lawful but either harm the public interest or weaken the capacity of the institution to achieve its primary purposes."


From Here On

It's a pertinent point because the reality is that, even if the Volcker Rule is adopted this week, it won't immediately become official policy.

The rule will still be subject to, at minimum, months of legal interpretations by the various agencies. That historically has often meant legal challenges by industry interests, which in turn could mean aspects of the Volcker Rule are put on hold until the litigation is final.

Finally, there is the simple fact that agencies can't possibly oversee all activities undertaken by financial institutions. JPMorgan, as one example, has $2.4 trillion in assets and operates in 60 countries.

"How supervision and enforcement of the Volcker provisions are handled among the five agencies is one of the most important and potentially complicated practical aspects of implementation," Julie Williams, former general counsel for the Office of the Comptroller of the Currency, told Bloomberg News last week.

In other words, the game continues.

This piece first appeared in the Lab of the Edmond J. Safra Center for Ethics at Harvard University with which CLMR has an institutional partnership.