Why Paul Volcker Soured on His Own Rule

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The Volcker Rule, which was passed as part of the Dodd-Frank financial reform bill and is supposed to ban risky trading by large banks, doesn’t have a lot of fans. Bankers have fought it. Republicans, like much of the Dodd-Frank bill, want to repeal it. And even some Democrats don’t think it will be all that effective. But among the Volcker Rule haters there is one name that stands out: Paul Volcker, who is the inspiration for the rule.

Last week, the former head of the Federal Reserve has this to say in an article in the New York Times about the eponymously named rule:

“I don’t like it, but there it is,” Mr. Volcker told me in his first public comments on the sprawling proposal.

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

From the start, Volcker rule was probably trying to do more than it possibly could. As a result, much like Sarbanes-Oxley we will probably be left with a rule that does too little and costs too much. Here’s why:

How did we get here? James Stewart’s NYT article on the Volcker Rule says a lot of people would like to revive Glass-Steagall, the Depression-Era rule that for 60 years prohibited Wall Street firms and regular banks from mixing, before it was repealed in the early 2000s. Volcker, too, says he would be for bringing back Glass-Steagall, but he says that’s impossible. It would be too hard to legislate, since the business of banking and Wall Street are so entwined these days.

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So Volcker came up with a tricky way around that problem. Instead, of proposing to re-split banking from Wall Street, he proposed that banks would have to dump their most profitable business over the past decade – prop. trading. Volcker’s thinking, I believe, was that if banks couldn’t prop. trade then they might just ditch their Wall Street businesses all-together. What’s more, in the wake of Lehman, the thinking was that the idea of banning risky trading by large bailout-prone banks would play well in Washington, and it did, at least enough to get passed. Unfortunately, the rest didn’t work out as Volcker planned.

Here’s the problem: Trading is core to so many of Wall Street’s functions. When an investment bank underwrites a company’s initial public offering, one of the few functions that Wall Street performs that pretty much everyone agrees benefits the economy, it takes a trading position. It is essentially buying into the company that is selling its shares to the public. Investment banks sometimes need to hold onto that position for a few months. And since managing IPOs is something we all want Wall Street to do, you need an exception to the trading rule. There are lots of little exceptions like that. Hedging, an exception. Selling derivatives, an exception. The result is that the Volcker Rule expanded from an original 3 page proposal to a nearly final version that clocks in at just under 300 pages. Volcker says the banks should blame themselves for making the rule so complicated, because they pushed for the all the exemptions. But Volcker is at least as much to blame. He tried fixing the financial system by using a side door, when he should have tackled the problem straight on.

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Prop. trading did in part lead to the collapse of Lehman and Bear. But not directly. The bigger problem was they didn’t have enough liquid capital to cover their activities. Shortly after the financial crisis, I wrote about the fact that the banks used their Wall Street arms to get into businesses that required less and less capital. That’s really what we should be trying to fix. So I say let the banks trade all they want. As we can see it’s too hard to get them out of it. Instead, I think a better way to tackle the problem would be to force banks to hold higher capital if they want to be in the business of trading. The riskier you want to make your bank the more capital you have to hold, offering shareholders and the U.S. government more protection if those risky bets go bad. What’s more, requiring banks to hold a lot of capital might just make it less attractive for banks to be in the business of trading, and they might get out of it, as well as other investment banking businesses as well. At least, that’s that plan.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel. You can also continue the discussion on TIME‘s Facebook page and on Twitter at @TIME.