WASHINGTON -- Federal regulators signed off Tuesday on tougher restrictions on banks engaged in complex financial trading, finally moving on one of the most complicated portions of the 2010 revamp of financial regulation.
The regulators individually approved language implementing the so-called Volcker Rule, named after former Federal Reserve chairman Paul Volcker, who as an aide to President Barack Obama proposed restricting the kinds of investments banks could get involved with if they are taking money from depositors or investors.
The regulators adopting the final language were the Federal Reserve, Federal Deposit Insurance Corp, the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission.
The Volcker Rule sought to limit risky investments in the lightly regulated derivatives markets, involving complex financial instruments that even the CEOs of major investment banks acknowledged during the 2008 financial crisis they didn't fully understand.
The long-delayed, 900-page rule will prevent banks from owning a stake larger than 3 percent in hedge funds and private-equity funds, investment vehicles for the ultra-wealthy. Big banks also will have to provide much more information to regulators about their complex investments to ensure that they are hedging against specific risks, not actually engaging in trading for profits. They'll also face restrictions for activities in which there are a limited number of players, often called market-making.
The biggest shock to giant banks is that they are now prohibited from engaging in so-called portfolio hedging. That's when they use one kind of investment to mitigate the risks in a broad portfolio of other investments. Banks will be allowed to hedge against risks made in their individual investments, but they cannot do it broadly across a range of investments. This practice was designed to offset risks while potentially earning great reward.
But JPMorgan Chase & Co. learned about the downside the hard way, when a trader in London accumulated a huge bet that went sour, costing the bank and its investors more than $6.2 billion. The derivatives products JPMorgan Chase had bought into in its so-called "London Whale" trade were supposed to hedge against credit risks, but they came to be viewed as a back-door way to trade for profit.
The financial regulation revamp is shorthanded as the Dodd-Frank Act after its authors, Rep. Barney Frank, D-Mass., and Sen. Christopher Dodd, D-Conn., both of whom have left Congress. One of the act's main tenets was to prevent banks that invest customer money from engaging in proprietary bets themselves.
In the aftermath of the 2008 financial crisis, it became clear that Goldman Sachs Group Inc. and other major banks bet against the very complex financial instruments under the guise of taking out protection. That protection became very profitable when complex mortgage bonds soured, soaking investors who bought them, but allowing banks to cash in on the insurance-like bets they had made on the very same products they previously had sold.
The final rules amounted to a defeat for trade associations that sought to weaken the rules. Among those criticizing the final product was the U.S. Chamber of Commerce.