Volcker Rule Sets Tough Standards, High Regulatory Expectations

Federal regulators moved to tighten banking rules to curb risky trading on Wall Street Thursday. The so-called Volcker rule, part of the 2010 Dodd-Frank regulatory overhaul, would preclude banks from making risky bets on their own accounts. Audie Cornish talks to Simon Johnson, a professor at MIT's Sloan School of Management, for more on what the rules will mean.

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AUDIE CORNISH, HOST:

For more on just how the Volcker rule will work and how it will be enforced, we're joined by Simon Johnson. He's professor at the MIT Sloan School of Management, and he's a member of the FDIC's systemic resolution advisory committee. Welcome to the program.

SIMON JOHNSON: Thanks for having me.

CORNISH: So let's talk more about proprietary trading. Give us some specific examples of this.

JOHNSON: Well, the most spectacular recent example is the so-called London whale trade by JPMorgan Chase, where they took some big bets in London and lost a lot of money, not because any customer asked them to but because some people inside the organization thought the risks were worth taking. Well, they weren't. And those kinds of losses on a grander scale are exactly what you should worry about in the banking system going forward.

CORNISH: You mentioned the London whale and this controversy over at JPMorgan. The head of JPMorgan, though, has insisted that that trading would not have been covered by a Volcker rule.

(LAUGHTER)

JOHNSON: Well, that's an interesting question. We're going to see going forward. My understanding is that the kind of betting that JPMorgan Chase was doing is absolutely not going to be allowed. Now, the argument of JPMorgan is, no, no, no, we were actually hedging our risks. Well, I don't know many people outside of JPMorgan who regard that as credible. So we're going to have some very interesting test cases along exactly these lines, including with offshore trading, including with trading in sovereign debt, for example, which is partially or largely exempt from many of the Volcker rule restrictions.

CORNISH: It sounds like you feel that we won't really know how good this rule is until there's been a bunch of test cases.

JOHNSON: That's right, absolutely. It's very much in the common law tradition that we like in the United States. There will be test cases. There will be details. There will be suits and countersuits. And out of that war in the trenches, if you like, we will see how tough the regulators are and how much the banks, the very big banks, can escape the intent of this very sensible rule.

CORNISH: So with five different agencies issuing this rule, does this make it harder or easier to enforce? I mean, is there a concern that banks will shop around for the most lax regulator?

JOHNSON: That shopping around for lax regulators has been a big issue in the past. It is harder to do today. We have a financial oversight council chaired by the secretary of the Treasury who is also going to try and, I think, prevent that. And the Federal Reserve has the primary responsibility for enforcing this rule for any institution that is of systemic significance. So I think the - while I would still worry about jurisdiction shopping, it's a little bit less of an issue going forward.

CORNISH: But in the last few years, have federal regulators prove to you that they can keep up with Wall Street? I mean, Wall Street is constantly creating new financial products to work around the rules.

JOHNSON: That's true. And then regulators falling behind the industry is always going to be an issue. The regulators have done better in the last four or five years than they did previously, than they did in any time in the 30 years prior to that. But the credit cycle is still very young. People will get exuberant. Credit will become even easier. There will be opportunities for excessive risk taking. And it's what happens over the next 10 years that are really going to be important.

CORNISH: How concerned are you about further delays to this rule or delays generally? There are many bank lawsuits challenging so many aspects of the Dodd-Frank law.

JOHNSON: So there will be lawsuits, to be sure. I wish that the regulators, in their decision today, had pushed for a quicker implementation. This rule will not be fully in effect until July 2015. And I think it will be hard for the bankers to stop it, the big banks, but they will try hard. So this is by no means over yet.

CORNISH: Simon Johnson, how significant is this part of the Dodd-Frank law to you? I mean, is this kind of symbolic that this rule was finally able to get off the ground or is this something that you see as being truly key to what the legislation intended?

JOHNSON: I think it's both. I think it's a very important part of the substance. It absolutely was a key intention of the president and of the Congress, and then, of course, of Paul Volcker, who should get a huge amount of credit today. It also has symbolic value. It became a very-high stakes battle. The financial institutions pushed back very successfully, I have to say, at the beginning. And then they got a huge amount of egg on their face after the losses that were incurred by JPMorgan Chase in its London whale derivative fiasco.

So it's been a salutary lesson, I think, for the regulators that they should hold the line, they should push back against the industry. And we're going to see now when it comes to implementation whether the regulators can live up to the expectations that they've laid out for themselves today.

CORNISH: Simon Johnson, he's a professor at the MIT's Sloan School of Management. He's also Senior Fellow at the Peterson Institute for International Economics. Thanks so much.

JOHNSON: My pleasure.

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