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
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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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