The "Volcker Rule' could clarify roles and risks in the financial system

FOR MONTHS, former Federal Reserve chairman Paul Volcker has been advocating a far-reaching repair plan for Wall Street: to re-draw the line between commercial and investment banking. Since the repeal of the New Deal-era Glass-Steagall Act in 2000 (and even, to a large extent, before that) deposit-taking institutions have been allowed to make money not only the old-fashioned way -- lending it out at interest -- but also by running hedge funds and other speculative means. Mr. Volcker argued that, since their deposits are federally insured, the big banks were enabled to take bigger risks for which the taxpayers would ultimately take the hit. He insisted that this incentive structure was not only unfair but also at the root of the current crisis. Correcting it, he argued, is the key to preventing future crises.

For months, Mr. Volcker's ideas made no impact on Obama administration policy. Both the administration's regulatory reform proposal and the House bill based on it took a different approach to "too big to fail": namely to raise capital requirements, set up a prospective government bailout mechanism and empower systemic risk monitors. Then Republican Scott Brown won the Senate race in Massachusetts. Two days later, Mr. Obama embraced both Mr. Volcker and his concept, and he even christened it "the Volcker Rule." No doubt, the embattled president likes the populist resonance of a plan to "break up" Wall Street. But what about the policy merits?

In hindsight, the U.S. financial sector systematically underpriced risk of all kinds. One reason for this -- though hardly the only one -- was the perception, rooted in reality, that certain enterprises were "too big to fail." Under the Volcker Rule, only less-risky commercial banks would in theory enjoy that status. Investment banks, hedge funds and private equity firms would be on their own, subject to market discipline in both good times and bad. Voilà: clear signals to the market.

It's an attractive concept. Alas, the hastily unveiled administration proposal was light on detail. How, exactly, to draw the line between financial operations safe enough for commercial banks and those that are not safe enough? Will a U.S. Volcker Rule drive more banking business to lightly regulated financial centers in other countries? It is not clear that the Volcker Rule would have prevented the current financial crisis, which began with the collapse of a pure investment bank, Lehman Brothers -- which many now say should have been rescued. Two non-commercial banks, Bear Stearns and AIG, did get rescued; their interconnection with other institutions, not size alone, frightened the government into saving them.

The buildup of government-backed risk in Fannie Mae and Freddie Mac -- both based in Washington, not Manhattan -- arguably did the most to inflate the mortgage bubble in the first place. Would the president's proposal apply to them?

Still, Mr. Volcker is right that, more than almost anything else, the financial system needs clarity as to the roles and permissible risk profiles of its component institutions. There is a fighting chance that the Volcker Rule's ambiguities can be ironed out in the debate to come. The president has injected a useful element into the debate. If we have Scott Brown to thank for that, so be it.