Behind the ‘Volcker Rule’: The Mutt-and-Jeff Team That Tackled Wall Street

How Paul Volcker and Gary Gensler took on the big banks — and won.

Former Federal Reserve Board Chairman Paul Volcker arrives at a hearing before the Financial Institutions and Consumer Protection Subcommittee of Senate Banking, Housing and Urban Affairs Committee May 9, 2012 on Capitol Hill.  
National Journal
Michael Hirsh
Dec. 11, 2013, midnight

As 2009 rolled on and the pan­ic re­ceded, Paul Vol­ck­er felt there was something very wrong with the Obama ad­min­is­tra­tion’s plans for re­form­ing Wall Street. But no one was listen­ing to him. The gruff-voiced, ci­gar-chomp­ing former Fed chair­man may have been nom­in­ally a mem­ber of the Obama team — chair­man of the pres­id­ent’s new Eco­nom­ic Re­cov­ery Ad­vis­ory Board — as well as a liv­ing le­gend of fin­ance, the conquer­er of run­away in­fla­tion in the ‘70s. But the then-82-year-old Vol­ck­er found that his rep wasn’t get­ting him any­where with the pres­id­ent’s in­ner circle, es­pe­cially Obama’s bank-friendly Treas­ury sec­ret­ary, Tim Geithner, and chief eco­nom­ic ad­visor Larry Sum­mers, both of whom had little time for him. In an in­ter­view in late 2009, Vol­ck­er said he felt some­what used early on by Obama (whom he had pub­licly backed for pres­id­ent)—merely trot­ted out for the cam­er­as dur­ing the pres­id­en­tial cam­paign, but then side­lined when the real de­cisions were be­ing made. “When the eco­nomy began go­ing sour, then they de­cided I could be some kind of sym­bol of re­spons­ib­il­ity and prudence of their eco­nom­ic policy,” he said with a wry smile.

What bothered Vol­ck­er was very simple: After hun­dreds of bil­lions of dol­lars in tax­pay­er bail­outs, he was ap­palled that the biggest banks—which Obama al­lowed to re­main in­tact even though they had caused the worst fin­an­cial crisis since the Great De­pres­sion—were be­ing per­mit­ted to re­sume their pre-crisis habits of be­hav­ing like hedge funds, trad­ing reck­lessly with tax­pay­er-guar­an­teed money. Vol­ck­er wanted a rule that would bar com­mer­cial banks from in­dul­ging in “pro­pri­et­ary” trad­ing (in oth­er words, gambling with cli­ents’ money for the firm’s own gain), thus cor­don­ing off fed­er­ally guar­an­teed bank de­pos­its and Fed­er­al Re­serve lend­ing from the heav­iest risk-tak­ing on the Street. It was the closest thing he could get to a re­turn of Glass-Steagall, the 1933 law that forced big banks like J.P. Mor­gan to spin off their ris­ki­er in­vest­ment bank­ing sides in­to new firms (in that case, Mor­gan Stan­ley) after the Crash that led to the De­pres­sion. Com­mer­cial banks that lie at the heart of the eco­nomy and are able to draw cheap money from the Fed dis­count win­dow “shouldn’t be do­ing risky cap­it­al mar­ket stuff,” Vol­ck­er told me. “I don’t want them to be Gold­man Sachs, run­ning a zil­lion pro­pri­et­ary op­er­a­tions.” But the pres­id­ent “ob­vi­ously de­cided not to ac­cept” his re­com­mend­a­tions, Vol­ck­er said then.

Chan­nel­ing the views of Wall Street, Geithner and Sum­mers thought Vol­ck­er’s pro­pos­als were not feas­ible: How was any­body sup­posed to know when a trade was “pro­pri­et­ary” as op­posed to a le­git­im­ate hedging or “mar­ket-mak­ing” trans­ac­tion for cli­ents. Just couldn’t work, they said. And so Vol­ck­er began trav­el­ing all over the coun­try to de­liv­er a series of speeches push­ing for even more fun­da­ment­al re­form of the fin­an­cial sys­tem—part­ing ways with both the Obama ad­min­is­tra­tion and most of the Con­gress.

By late 2009 and early 2010—es­pe­cially after the stun­ning spe­cial Sen­ate elec­tion res­ult in Mas­sachu­setts gave the once-Demo­crat­ic seat to a Re­pub­lic­an, Scott Brown—Obama began to think that his ad­min­is­tra­tion looked vul­ner­able on the is­sue. Ac­cord­ing to a seni­or ad­min­is­tra­tion of­fi­cial in­volved in eco­nom­ic policy-mak­ing, the pres­id­ent came to be­lieve that Geithner and Sum­mers hadn’t gone far enough with fin­an­cial re­form. They had, in fact, res­isted al­most every struc­tur­al change to Wall Street, not only Vol­ck­er’s plan but also Arkan­sas Sen. Blanche Lin­coln’s idea to bar banks from swaps trad­ing. And Wall Street didn’t seem to be chan­ging on its own: In Decem­ber 2009, the pres­id­ent was out­raged to hear that year-end bo­nuses would ac­tu­ally be lar­ger in 2009 than they had been in 2007, the year pri­or to the cata­strophe. “Wait, let me get this straight,” Obama said at a White House meet­ing. “These guys are re­serving re­cord bo­nuses be­cause they’re prof­it­able, and they’re prof­it­able only be­cause we res­cued them.” And so at a meet­ing late that year in the Roosevelt Room, Obama said: “I’m not con­vinced Vol­ck­er’s not right about this.” Vice Pres­id­ent Joe Biden, a long­time fan of Vol­ck­er’s, bluntly piped up: “I’m quite con­vinced Vol­ck­er is right about this!”

Obama form­ally pro­posed the rule at a White House news con­fer­ence on Jan. 21, 2010 with Vol­ck­er in rare at­tend­ance, an­noun­cing: “We’re call­ing it the Vol­ck­er Rule after the tall guy be­hind me.” Sen­at­ors Jeff Merkley, D-Ore., and Carl Lev­in, D-Mich, later form­ally in­tro­duced the rule in­to the Dodd-Frank law. But even then Geithner dragged his feet on im­ple­ment­a­tion, and for the next two and a half years Wall Street law­yers loaded the pro­pos­al down with loop­holes and ex­emp­tions.

The Vol­ck­er Rule was, in fact, in grave danger of be­ing loop­holed to death right up un­til its ad­op­tion this week. And in the end it was largely one reg­u­lat­or, more than any oth­er, stood firm against those ef­forts and man­aged to avert the worst of the wa­ter­ing down: Gary Gensler, the out­go­ing chair­man of the Com­mod­ity Fu­tures Trad­ing Com­mis­sion. As di­min­ut­ive in stature as Vol­ck­er is tower­ing, Gensler was the Jeff to Vol­ck­er’s Mutt, an es­sen­tial part of a de facto team.

Like Vol­ck­er, the 56-year-old Gensler was also something of a rel­ic from an earli­er era, not ne­ces­sar­ily the per­son you would ex­pect to be tak­ing on Wall Street in the second dec­ade of the 21st cen­tury. Serving un­der Treas­ury Sec­ret­ary Robert Ru­bin in the ‘90s, Gensler had helped to open the way to massive de­reg­u­la­tion of the banks, ul­ti­mately lead­ing to the subprime mort­gage crisis. As a res­ult, pro­gress­ive sen­at­ors such as Bernie Sanders, I-Vt., and Maria Can­t­well, D-Wash., even put on a hold on his CFTC nom­in­a­tion at first. But in testi­mony and later on in in­ter­views, Gensler be­came one of the very few former Clin­ton or Bush ad­min­is­tra­tion of­fi­cials to ad­mit his er­rors of judg­ment in free­ing up fin­ance in the ‘90s. And as CFTC chief, he sought to make right what had gone so ter­ribly wrong.

It was Gensler, us­ing the un­matched ex­pert­ise he had de­veloped in the pre­vi­ous three years crack­ing down on over-the-counter de­riv­at­ives trad­ing—which is the main source of the banks’ pro­pri­et­ary profits—who mainly led the charge to toughen the Vol­ck­er Rule and ex­tend it world­wide, es­pe­cially when it be­came clear that banks could evade it by shift­ing trad­ing to their over­seas op­er­a­tions, by sev­er­al ac­counts. Along with Se­cur­it­ies and Ex­change Com­mis­sion­er Kara Stein, he was also the key play­er be­hind a crit­ic­al pro­vi­sion that places the bur­den of proof on the banks to jus­ti­fy that activ­it­ies they are en­gaged in are not pro­pri­et­ary trad­ing, for­cing them to provide a reg­u­lar ana­lys­is cor­rel­at­ing such trades to ap­pro­pri­ate hedges or oth­er ap­proved activ­it­ies. Giv­ing ad­di­tion­al teeth to the rule, Gensler and the oth­er reg­u­lat­ors also forced the banks to re­strict their hedging to spe­cif­ic iden­ti­fi­able in­vest­ments and ban so-called port­fo­lio hedging—which had al­lowed the banks to en­gage in com­plic­ated trades pu­tat­ively to hedge against gen­er­al risks across a broad port­fo­lio of in­vest­ments. Gensler held up as a cau­tion­ary tale the no­tori­ous “Lon­don Whale” epis­ode, when even a blue-chip bank like JP­Mor­gan was found to be mak­ing de­riv­at­ive bets that cost $6.2 bil­lion in losses and mask­ing them as a port­fo­lio hedge. Gensler “went to the mat on that is­sue,” says Mi­chael Green­ber­ger, a Uni­versity of Mary­land reg­u­lat­ory ex­pert and a some­time ad­visor to the CFTC.

By tak­ing the bat­on from Vol­ck­er, and push­ing al­most alone to reg­u­late tril­lions in de­riv­at­ives trades over­seas, Gensler ini­tially earned him­self en­emies in the Treas­ury De­part­ment and White House, es­pe­cially when European and Asi­an gov­ern­ments began com­plain­ing about his ef­forts to ex­tend his pur­view to U.S. banks’ over­seas activ­it­ies. Helped by in the end by Treas­ury Sec­ret­ary Jac­ob Lew, who proved much more eager to en­dorse his ef­forts than Geithner had been, Gensler won over less en­thu­si­ast­ic reg­u­lat­ors. In a re­cent speech that could al­most have been writ­ten by Gensler, Lew praised the rule as “true to Pres­id­ent Obama’s vis­ion” and echoed Gensler in say­ing that it was in­ten­ded to pro­hib­it “risky trad­ing bets like the ‘Lon­don Whale’ that are masked as risk-mit­ig­at­ing hedges.”

Now, with little fan­fare, Gensler is on his way out at the CFTC—per­haps the most un­sung hero of the en­tire post-fin­an­cial crisis peri­od—and the ef­fect­ive­ness of the Vol­ck­er Rule re­mains to be seen, es­pe­cially since reg­u­lat­ors have put off im­ple­ment­a­tion un­til 2015. The banks will no doubt sue to change it fur­ther. But even some skep­tics of Dodd-Frank think it could be the biggest break­through yet against the con­cen­trated power of Wall Street banks. It “will not end all gambling activ­it­ies on Wall Street, but should lim­it them and re­duce the risk to Main Street,” Den­nis Kelle­her, the head of the ad­vocacy group Bet­ter Mar­kets, said in a state­ment. Thanks largely to the odd couple of Paul Vol­ck­er and Gary Gensler, the rule may yet prove to be the single most ef­fect­ive solu­tion to the too-big-to-fail prob­lem.

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