Showing why complex financial regulations fail: Regulators clash over Volcker Rule definitions

A Wall Street Journal article on regulators clashing over Volcker Rule definitions highlights why complex financial regulations have loopholes that the banks and their lobbyists will expand over time until they ultimately render the complex regulations irrelevant.

Mr. Volcker made this point when he testified before the UK Parliament last week.

Complex financial regulations fail because they substitute rules and regulatory oversight for transparency and market discipline.

A rift has emerged among regulators responsible for crafting the so-called Volcker rule, one of the most complex and contentious regulations of the landmark Dodd-Frank financial overhaul. 

The dispute ... raises the unattractive possibility that the agencies will issue conflicting standards. 

The SEC and a trio of banking regulators are butting heads over how to define the buying and selling of securities on behalf of clients, known as market-making, as well as over banks' ability to invest in outside investment vehicles such as hedge funds, according to officials close to the discussions....

Regular readers know that your humble blogger thinks that the Volcker Rule could be written on one page.

Paragraph one would restate the ban on banks making proprietary bets and the limits on investing in hedge funds and similar investment vehicles.

Paragraph two would require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, the market could monitor the banks and see if they were in compliance with paragraph one.

As an added incentive to comply with paragraph one and not engage in proprietary gambling, traders at the banks would know that market participants could see their positions and engage in activities that would lower the profit potential from the proprietary bets.

Besides the disagreement between the SEC and banking regulators regarding market-making, the other main point of contention involves how to define the funds in which banks are prohibited from investing. 

The law specifies that banks are limited in investing or owning hedge funds or private-equity funds, but defines those terms broadly. In a study of the Volcker rule, the Treasury Department recommended the agencies consider narrowing the definition to avoid unintentionally capturing too many investment vehicles....

Again, by requiring ultra transparency, we get around the need for anything beyond the broad definitions already in the law.

Industry officials warn that conflicting versions of the Volcker rule would be a recipe for chaos, with banks unable to be sure which regulators' rule applied to a particular transaction.

Better not to have 300 pages of rules in the first place when 1 page with 2 paragraphs will do a better job of fulfilling the intent of the Volcker Rule and restricting risk taking by the banks.