Reviews of the final Volcker rule have been mostly positive among financial reformers and, perhaps more tellingly, mostly negative among banks. Speaking for the Financial Services Roundtable, Tim Pawlenty warned that the rule "will reduce needed access to capital." That's Wall Street for "ouch". If the banks didn't say that, you'd know the Volcker rules wasn't worth the paper it was printed on. (On the other hand, shares of both JP Morgan and Goldman Sachs rose on Tuesday.)

Sen. Jeff Merkley speaks with Paul Volcker. (Merkely's office.)
Sen. Jeff Merkley (D-Ore.), left, speaks with former Federal Reserve chairman Paul Volcker. (courtesy Sen. Jeff Merkley's office.)

But a conversation I had with Sen. Jeff Merkley, one of the regulation's most ardent backers, was a reminder of how difficult it will be for the Volcker rule -- and much of Dodd-Frank -- to work when it's most needed.

I asked Merkley whether he was happy with the rule. "By and large yes," he said. "But the real proof will be how regulators enforce them. There's a lot of wiggle room for regulators." That's a giant, red flashing light. Almost by definition, a financial bubble can only occur during a period when regulators are inclined to give banks a lot of leeway. If the Volcker rule doesn't work in periods of bubble psychology, it's not going to be much of a defense against bubbles.

The Volcker rule is meant to keep commercial banks from making speculative trades with money that taxpayers insure. The problem is defining what's a speculative trade and what's a bank simply helping its customers take a position. Wonkblog's Neil Irwin offers a nice example:

Suppose you are a regulator and you see that a bank you oversee holds millions of dollars' worth of options betting that the value of, say, the Brazilian real will fall relative to the dollar. "What is this!" you say. "You are speculating that the real will fall against the dollar. You know you aren't allowed to speculate on currencies under the Volcker Rule."

The banker replies, "What are you talking about? I'm not speculating on the Brazilian currency! I have this huge loan that I made to a Brazilian construction company. And they make all their money in reals. So all I'm doing is guarding myself against the risk that the real falls, and I won't get my loan repaid. This is reducing the risk that the bank faces, not increasing it!"

The Volcker rule's answer is to force banks to tell regulators which risks their trades are hedging. And their answer can't be, "You know, like, the risks of life, man." They need to identify the specific trades they're hedging against. If nothing else, that creates a lot of paperwork for a commercial bank that wants to run an internal hedge fund.

"Trying to hide proprietary trading inside offsetting risks will be very burdensome," says Merkley. "That will drive the proprietary trading where it should be -- inside legitimate hedge funds."

At least, it will for now. The danger comes when the bubble appears and regulators begin to believe that 2013's regulations can't possibly apply to a world in which banks have come up with [insert mind-numbingly complex financial innovation here].

That raises the possibility -- which exists with a lot of financial rules that rely on regulatory discretion -- that the rule will be enforced too aggressively in periods when it's not badly needed and too loosely in periods when it is badly needed.

"I’m not confident this will be working 10 or 15 years from now," Merkley acknowledges. "That depends very much on the folks who are working as regulators."