Federal regulators ought to start over on the Volcker Rule, and get back to basics.

Policymakers could meet the July 21 effective date if they stripped the plan down to its essence.
"We need to state the principle and put it back on the boards and managers to have the appropriate policies in place that you can approve and transaction test when the examiners go in," said Sheila Bair, the former Federal Deposit Insurance Corp. chair who is now a senior advisor at the Pew Charitable Trusts.

The Volcker Rule, as proposed, is "trying to tell bank managers how to run their banks. This transaction is OK, and this one isn't. This one may be OK if you call it this and you put it in the banking book. We're going to have the lawyers running the banks."

So what might a simple version of the rule look like? How about this: the government tells banks they may not trade as a principal to profit from near-term price movements. It requires adoption of policies and procedures to ensure compliance. Examiners are empowered to enforce the rules. When violations occur, executives and boards face tough punishment including anything from fat fines to higher capital charges.

Wouldn't that make more sense than the confusing course we're on?

Even Barney Frank, the reform law's co-namesake, said last week that he's willing to let the deadline slip to Labor Day if regulators will "significantly" simplify the rules. In a statement, he urged the regulators to "state basic principles and apply appropriate flexibility."

The Massachusetts Democrat noted the law allows for a two-year period that will give regulators an opportunity to "learn from actual experience and make appropriate adjustments."

No one wants to rob markets of critical liquidity and everyone understands that the line between proprietary trading and market making is blurry. But that does not mean it is impossible to tell if a bank is trading massive amounts of money for its own account.

"They have to go back to something simple and clean or they risk doing significant damage to the markets," said Kathy Dick, a managing director at Promontory Financial Group and former senior regulator at the Office of the Comptroller of the Currency.

"With the right resources, examiners can take the concepts from the Volcker statute, complement it with simple, clean regulation, and use the metrics as red flags. I think with that approach they can detect proprietary trading."

The "metrics" Dick references are essentially red flags. The more a company trips them, the more likely it's trading on its own behalf.

A January 2011 report by the Financial Stability Oversight Council lays out a sensible approach, including the use of four categories of quantitative metrics dealing with revenue, risk, inventory and the volume of customer-initiated trades. By October 2011, when four federal agencies issued the proposed rule, those metrics had multiplied and some 400 questions were added. That led to a whole lot of confusion — and plenty of criticism.

"The regulators created this Rube Goldberg mousetrap to go after 1% of the potential risk with 90% of the rule," said Ken Bentsen, the executive vice president for public policy at the Securities Industry and Financial Markets Association. "We think you could reverse the rebuttal presumption to make it very clear that customer-related principal trading activity is exempted market-making activity."

The Federal Reserve says it has received nearly 19,000 letters on the proposal. Only 383 are detailed responses; the rest are one of five different form letters.

(A fifth agency, the Commodity Futures Trading Commission, didn't issue its version of the proposed rule until February. Comments aren't due on that until April 16.)

Amy Friend, another managing director at Promontory who worked for Sen. Chris Dodd when the reform law was being drafted, said the regulators have ended up exactly where Congress feared.
"Where we are now has in many ways played out exactly as we were concerned would happen: that this would become an exercise in line-drawing. And who knows how to really do that?
"It seems to make sense to dial it back, use the metrics and the conformance period to test these things and let the regulators refine their understanding," Friend said. "If they have the benefit of time to collect these metrics, analyze what they mean and work with the industry to try to figure out their utility in a very iterative way, that would be prudent. It feels to me like the process needs to develop more organically."

Some experts don't like the particular metrics recommended in the Financial Stability Oversight Council report or the proposed rule. That's OK. Regulators could select a manageable number and try it out. Figure out what works and what doesn't and then modify the rule and its enforcement.

My idea will no doubt cause some eyes to roll. It's too naive — surely a complicated business needs a complicated regulation — and examiners can never match wits with clever investment bankers. But can we allow that to be true? Our system relies on quality supervision. In fact, Dodd-Frank doubled down on that concept.

So we could settle on some metrics and train a corps of examiners to evaluate the handful of trading banks. Would every speculative trade be stopped? No. But that can't be the goal.
What a Volcker Rule should do is create a new mind-set around trading. It should urge companies to put the customer first, and threaten punishment for missteps. That would result in change consistent with the vision former Fed Chairman Paul Volcker has outlined.

"What you are really trying to do is set a culture at these banks of customer service," Bair said. "You make your money by providing a service to customers. Don't make your money by betting on a market movement. That's really the culture you want to pervade the organization."
So let's start with some broad principles — we can tighten them down the road if necessary — and require companies to explain how they plan to comply, send examiners in to check and hold executives accountable.

"If there is a proprietary loss, there should be some financial repercussions" for senior executives and boards of directors, Bair said. "That will change the culture really fast, much more so than lawyers just trying to figure out how to arbitrage all these activity restrictions."

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