US regulators approved the so-called Volcker rule on Tuesday, which seeks to stop banks from taking the kind of trading risks that led to the 2008 financial crisis and costly taxpayer-funded bailouts.
The rule is a key part of the 2010 banking reform legislation otherwise known as the Dodd-Frank Act, which was introduced in the wake of the meltdown on Wall Street that triggered the worst recession in decades.
The Volcker rule, named after former Federal Reserve Chairman Paul Volcker who championed the reform, bans banks, such as JPMorgan and Morgan Stanley, from betting their own government-insured assets, a practice known as “proprietary trading.”
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While proprietary trading has been a huge profit generator for the banks, it also cost US taxpayers billions of dollars in bailouts when those bets went wrong in the lead up to the recession.
The Federal Reserve Board and the Federal Deposit Insurance Corp. board approved the finale version unanimously, while the Securities and Exchange Commission voted 3 to 2 in favor and the Commodity Futures Trading Commission voted 3 to 1.
Several banks have already closed down their proprietary trading desks.
The Volcker rule will also restrict the ability of banks to invest in hedge funds and private equity. Under the new regulation, they will be barred from owning more than 3 percent of such high-risk trading vehicles.
It also seeks to stamp out so-called portfolio hedging, a practice in which banks make trades to protect against losses in a broad portfolio of assets.
While hedging against potential losses is standard practice in investment banking, such trades can also be a veiled attempt to profit from a decline.
Coming up with definitions of what is a legitimate trade and what is an illegitimate has been a major hurdle to the implementation of the Volcker rule.
Not surprisingly, banks say Volcker goes too far and will hamper legitimate trading; backers of the reform say it will create safer financial markets.
“What the Volcker rule is supposed to do is stop that type of gambling because it's very high-risk, and if those bets go the wrong way like they did in 2008, they can not only threaten the bank itself, but the entire financial system, which is what we saw," Dennis Kelleher of Better Markets, a nonprofit group that pushes for tighter regulation of US financial markets, told the BBC.
Five regulators, including the Federal Reserve, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corp, the Office of the Comptroller of the Currency and the Securities and Exchange Commission, are expected to sign off on the law.
President Barack Obama said the Volcker rule would make markets and the American public more secure. "The Volcker Rule will make it illegal for firms to use government-insured money to make speculative bets that threaten the entire financial system, and demand a new era of accountability from CEOs who must sign off on their firm’s practices," he said in a statement.