Rube Goldberg Goes to Washington: Wall Street's Regulation Complexification Overtakes Volcker Rule

"Dealing with complexity is an inefficient and unnecessary waste of time, attention and mental energy. There is never any justification for things being complex when they could be simple." -- Edward de Bono, Maltese psychologist and author, nominated for Nobel Prize for Economics, 2005

Much blame for the 2008 credit crisis has been laid on proprietary trading, a speculative practice in which banks trade for their own profit (as opposed to commissions) using their own money (as opposed to clients'). This risky trading not only results in volatile returns, but is of no direct value -- and in some cases, causes harm -- to banks' customers. In reponse to this, Paul Volcker, the former Federal Reserve Chairman who currently chairs President Obama's Economic Recovery Advisory Board, sent the president a letter in 2009 proposing limits on proprietary trading.

The letter was just three pages, according to New York Times business columnist James Stewart, who recently wrote about the increasing complexity of the so-called "Volcker Rule," which grew to ten pages when it went to Congress last year as Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Then, when it was released for public comment on October 11, the rule -- which Stewart says "could be the most important reform measure to emerge from the financial crisis" -- had ballooned to 298 pages, with more than 1,300 questions and some 400 topics.[1] Talk about inflation.

COMPLEXIFICATION: HOW TO LOSE FRIENDS AND MYSTIFY PEOPLE

The rule, it seems, went through a process that Wall Street knows all too well: complexification, that murky art from which such exotic and opaque financial instruments as credit default swaps were born, only to fuel the dark and deregulated markets that helped bring about the financial collapse. And now, thanks to multimillion-dollar lobbying efforts by banks (In May, for example, Reuters reported that Goldman Sachs "hired an all-star team of lobbyists and former government officials...to get its message across to regulatory and political leaders"[2]), the Volcker Rule is littered with exemptions (read: loopholes), is murky at best and permits too much self-regulation by the banks. The rule meant to regulate risky trading has essentially been rewritten by many of the same risky traders who brought about the financial collapse through -- you guessed it -- risky trading.

And here's the real rub: These same firms, Stewarts writes, are now claiming that the rule is "too complex to understand and too costly to adopt." Frank Keating, president and CEO of the American Bankers Association, said, "Only in today's regulatory climate could such a simple idea become so complex...How can banks comply with a rule that complicated?"[3] Rube Goldberg, the cartoonist famous for his drawings of overly complex machines made to perform very simple tasks, might have chuckled -- if this piece of legislation were about regulating his "Self-Operating Napkin." But, at least in theory, it is critical to the future of America's financial health, especially since the Glass-Steagal Act, the 1933 law designed to limit speculation, was repealed in 1999 -- a repeal that led to the deregulation that led to the crisis. Does it feel like we're going in circles yet?

THE VOLCKER RULE, SIMPLIFIED

Thankfully, the Office of the Comptroller of the Currency (OCC), which made the request for public comment on the rule, has broken it down: "Section 619 generally contains two prohibitions. First, it prohibits federally insured depository institutions and their affiliates (banking entities) from engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments for a banking entity's own account. Second, it prohibits owning, sponsoring, or having certain relationships with, a hedge fund or private equity fund." Under the rule, banks must establish internal compliance programs that are subject to "supervisory oversight" and those with "significant trading operations" must report "quantitative measurements" that will identify prohibited proprietary trading and "high risk trading assets and strategies."[4]

Yes, it's got self-regulation written all over it, but still the banks don't like it, and neither do consumers. "Unfortunately, the proposal issued today falls well short of what the Volcker Rule could and should achieve," said the consumer rights coalition Americans for Financial Reform.[5] And Volcker himself is displeased with what has become of his basic recommendations. "I'd write a much simpler bill," he told Stewart. "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."

FOXES IN CHARGE OF THE HEN HOUSE: BACK TO THE DARK MARKETS (AND LOTS OF ACRONYMS)

Reviewing Satyajit Das's new book, "Extreme Money: Masters of the Universe and the Cult of Risk," The Economist recalled the 1998 bankruptcy of the hedge fund Long Term Capital Management, saying it was "a classic example of how those in the financial sector can be too clever by three-quarters...They have excessive faith in their own skill when their past profits have been the result of luck and heavy borrowing, disguised with sophisticated financial structures, often carrying acronyms that seem designed to baffle the uninitiated."[6] Well, it seems we're edging back to the dark markets. Reading the Volcker Rule, Stewart hit a wall, saying that he "made it through about five pages before sinking in a sea of acronyms." (S.O.S., anyone?)

Concerned about what the Volcker Rule could do to the banking sector, Goldman chief Lloyd Blankfein recently met with SEC chairman Mary Schapiro, as his lobbyists worked both sides of the aisle in Washington. Blankfein should be more concerned about his bank's underlying profitability. On Friday, Goldman shares closed at 102.09, more than 6 points lower than its close over two-and-a-half years ago, on March 27, 2009, just two weeks after Blackstone CEO Stephen Schwarzman sent a chill that reverberated well beyond the financial sector when he announced that 45 percent of the world's wealth had been destroyed by the international credit crisis.[7][8]

MORE THAN A CENTURY AFTER ROOSEVELT'S "NEW NATIONALISM," IT'S BUSINESS-AS-USUAL

The Volcker Rule is due to be implemented on July 21, 2012. What it will look like at that point and how it will be implemented remains to be seen. But what its two-year saga has shown is that until corporations and the regulators who regulate them are decoupled when it comes to writing legislation, "regulation complexification" will continue, lobbyists will exert too much control, loopholes will be drawn and self-regulation will water down laws meant to protect consumers.

"There can be no effective control of corporations while their political activity remains," said President Theodore Roosevelt in his "New Nationalism" speech on August 31, 1910. "To put an end to it will be neither a short nor an easy task, but it can be done."[9] Can it? Over a century, 18 recessions and two depressions later, what has really changed? In the beginning, the Volcker Rule was short and easy, yet it has morphed into something that no one, not even its author, likes. Welcome to the continuing travails of regulation complexification and the ghost of Rube Goldberg, courtesy of Wall Street.

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