The Real Questions to Ask at Volcker's Unveiling

Beyond the drama and intrigue generated by the forthcoming regulators' vote on a tougher-than-expected Volcker rule, there is a deeper and more profound question: If the activities in question are really that bad, how did we get this far before correcting them?

Inevitably, the Volcker Rule will be analyzed ad nauseam in the coming weeks and months, but what will it do in terms of reining in risk that banking regulators are not already addressing? Said another way, is the Volcker Rule really protecting us or just protecting us from ourselves?

In many respects, the Volcker Rule is being portrayed as a magic bullet that will cure many of the "ills" of Wall Street. In fact, many banks targeted by the rule already learned their lesson long ago. Smart, sophisticated bankers do not typically take wildly speculative risks. Rather, they take calculated risks that account for a multitude of factors during their decision-making process. And sometimes these bankers make mistakes or miss something. Or, alternately, someone does something that they were not supposed to do and it gets by everyone else. These are almost always internal systems failures and sometimes cultural failures. However, rarely, if ever, are failures based on a lack of appreciation of the risks posed by the activity in question.

Soon we will hear – and eventually understand – just how far the regulators decided to go to protect us from risks that the industry should already appreciate and understand. Certainly, the Dodd-Frank Act implemented numerous important reforms that have strengthened the banking system and the financial services industry. Key areas of improvement include major reforms to the swaps markets, orderly liquidation authority and the living will process, stronger capital requirements and numerous other improvements. Yet, ironically, industry observers and policymakers seem to be placing undue emphasis on a provision that, generally, would have done nothing to avoid the recent financial crisis. That, in itself, does not mean the Volcker Rule is a bad idea. Some even suggest that proprietary trading helped fuel a culture that set up the house of cards. Ultimately, however, the Volcker Rule has to be judged like any other regulation: do its benefits outweigh its costs?

On this score, we know the stakes are high. The two activities addressed by the Volcker Rule –proprietary trading and sponsoring/investing in hedge funds and private equity funds – generate significant earnings for the banking industry. Yes, particularly the largest banks. However, that income also supports numerous, less profitable but still important aspects of these banks' operations, including lending.  The activities in question are also important to other parts of our financial system, particularly the securities and capital markets. No one really knows how scaling down or eliminating these activities will impact the banks or these markets.

Additionally, any cost-benefit analysis must also take into account the potentially considerable compliance burden the final Volcker Rule creates. This cost may – and likely will – extend beyond the largest banks, since they're not the only ones that engage in the activities the Volcker Rule addresses. As such, its implementation has the potential to impose significant compliance burdens, while providing little if any benefits to a large chunk of the industry.

Thus, while Congress has instructed the regulators to address certain perceived risks with the Volcker Rule, it has left it to the regulators to determine how to implement these instructions in a manner that does not destabilize the markets. Whether the impact has a destabilizing effect may have more to do with the manner and "body language" of the regulators in implementing the rule, than the language of the final rule itself.

Like it or not, the ball remains in the regulators' court. How they respond in the coming months and react to the Volcker Rule's inevitable implications will be of much greater consequence than what we read about next week. On this point, while the certainty of a final rule will help provide stability, the process in which the regulators reached an apparently strained consensus could certainly foreshadow problems down the road.

Kevin L. Petrasic is a partner at Paul Hastings.