March 9, 2012

ENACTED IN 2010 as part of the Dodd-Frank financial reform law, the “Volcker Rule” bans commercial banks from speculating in hedge funds and the like. The purpose, according to its eponymous advocate, former Federal Reserve chairman Paul Volcker, is to prevent banks from taking excessive risks with the funding advantage federal deposit insurance gives them. Such “proprietary trading,” Mr. Volcker argued, destabilized the entire financial system for the sake of nothing more than bank profits and trader bonuses.

What could be simpler? Well, as it turns out, almost anything. When the Federal Reserve and other federal agencies attempted to translate Dodd-Frank’s language into specific regulation — under aggressive kibitzing by the bank lobby, of course — the result was a 298-page proposed rule, over whose many exceptions and qualifiers interested parties continue to squabble. As Fed Chairman Ben S. Bernanke has conceded, the regulators will be hard-pressed to produce a final regulation by the July 21 deadline.

A major new sticking point is the scope of a proposed exception to the Volcker Rule for U.S. Treasury bonds and municipal bonds. In essence, regulators proposed to permit banks to continue trading these securities on their own accounts — because otherwise federal, state and local governments would find it more expensive to market their debt, which is generally pretty safe anyway.

This plan is under attack from two directions. U.S. quasi-governmental state and local agencies such as water authorities argue that the exception doesn’t go far enough: They want it to include their debt, too, as the New Deal-era law on which the Volcker Rule is modeled did. Meanwhile, the governments of U.S. trading partners such as Canada and Europe say the exception goes too far: It bars trading in their government bonds, leaving them at an unfair disadvantage to U.S. Treasuries.

There is no question that imposing the Volcker Rule on any class of securities will make those instruments less liquid; otherwise, why would federal, state and local governments have sought an exemption for their debt? But as Mr. Volcker reminded his European critics in a recent Financial Times column, leaders in Europe have called for a tax on all financial transactions, a far more onerous burden on securities trading — and Europe’s sovereign debt hasn’t exactly been a market winner of late. Even if U.S. banks can’t speculate in it, hedge funds and others would still be free to do so.

Less clear, however, are the principled reasons for favoring U.S. Treasuries over German or Canadian bonds, both of which are higher-rated than American debt. As for excluding state and local quasi-governmental agency debt, that, too, is hard to defend, since it is generally no riskier than government bonds, as Citigroup analyst George Friedlander has argued.

It’s a given that the Volcker Rule raises costs — the whole point of the regulation is that this is the price we must pay for a social good, namely financial stability. Where the critics have a point is in their insistence that those costs be distributed fairly and rationally in relation to their benefits. U.S. regulators have to draw the lines somewhere, but as they do so, they must take legitimate concerns into account.