Federal regulators on Tuesday signed off on tougher restrictions on banks engaged in complex financial trading, finally moving on one of the most complicated portions of the 2010 revamp of financial regulation.
The regulators individually approved language implementing the so-called Volcker Rule, named after former Federal Reserve Chairman Paul Volcker, who as an aide to President Barack Obama proposed restricting the kinds of investments banks could get involved with if they are taking money from depositors or investors.
The regulators adopting the final language were the Federal Reserve, Federal Deposit Insurance Corp, the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission.
"It achieves the important balance," CFTC Chairman Gary Gensler said in a statement Tuesday before the vote.
The Volcker Rule sought to limit risky investments in the lightly regulated derivatives markets, involving complex financial instruments that even the CEO's of major investment banks acknowledged during the 2008 financial crisis that they didn't fully understand.
The long-delayed, 900-page rules will prevent banks from owning a stake larger than 3 percent in hedge funds and private-equity funds, investment vehicles for the ultra wealthy. Big banks will also have to provide much more information to regulators about their complex investments to ensure they are hedging against specific risks and not actually engaging in trading for profits. They'll also face restrictions for activities in which are a limited number of players, something called market making.
"The deliberative process leading to today's joint rule has been informed by a careful balancing throughout the final rule of the various prudential, economic, and other factors considered over the last three years," SEC Chairman Mary Jo White said in a statement after the vote.
The biggest shock to giant banks is that they are now prohibited from engaging in so-called portfolio hedging. That's when they use one kind of investment to mitigate the risks in a broad portfolio of other investments.
Banks will be allowed to hedge against risks made in their individual investments but cannot do it broadly across of range of investment. This practice was designed to offset risks while potentially earning great reward. But JP Morgan Chase learned about the downside the hard way when a trader in London accumulated a huge bet that when soured cost the bank and its investors more than $6.2 billion.
The derivatives products JP Morgan Chase had bought into in the so-called London Whale trade were supposed to hedge against credit risks but came to be viewed as a backdoor way to trade for profit.
The revamp of financial regulation is shorthanded as the Dodd-Frank Act after its authors, Rep. Barney Frank, D-Mass. and Sen. Christopher Dodd, D-Ct., both of whom have left Congress. One of the act's main tenets was to prevent banks who invest customer money from engaging in proprietary bets themselves.
In the aftermath of the 2008 financial crisis, it became clear that Goldman Sachs and other major banks bet against the very complex financial instruments under the guise of taking out protection. That protection became very profitable when complex mortgage bonds soured, soaking investors who bought them but banks cashed in on the insurance-like bets they'd made on the very same products they'd sold.
The final rules amounted to a defeat for trade associations that sought to weaken the rules. Among those criticizing the final product was the U.S. Chamber of Commerce.
"The Volcker Rule is the most complex rule stemming from the already convoluted Dodd-Frank law, and its impacts will have a significant effect on the broader economy," warned David Hirschmann, president of the chamber's Center for Capital Markets Competitiveness. "The Volcker Rule may shut Main Street businesses out of some markets, raise the costs of capital, and place the United States at a competitive disadvantage in a global economy."