As part of the Dodd-Frank financial reform, banks will be barred from trading for their own profit instead of their clients under a rule being proposed by federal regulators.

Yahoo!Finance reports FDIC backs ban on banks trading for own profit

The Federal Deposit Insurance Corp. backed the draft rule on a 3-0 vote Tuesday. The ban on proprietary trading was required under last year’s financial overhaul law.

For years, banks had bet on risky investments with their own money. But when those bets go bad and banks fail, taxpayers could be forced to bail them out. That’s what happened during the 2008 financial crisis.

The Federal Reserve has also approved the draft of the so-called Volcker Rule, which was named after former Fed Chairman Paul Volcker.

The Securities and Exchange Commission and Treasury Department must still vote on it, and then the public has until January 13 to comment. The rule is expected to take effect next year after a final vote by all four regulators.

Wall Street banks have complained that the ban on proprietary trading could prevent them from buying and selling investments that their customers might want. It would also put U.S. financial firms at a competitive disadvantage to those in other countries.

At the same time, several big U.S. banks have already shut down their proprietary trading operations in response to enactment of the financial overhaul.

The rule also would limit banks’ investments in hedge funds and private equity funds, which are lightly regulated investment pools. Banks wouldn’t be allowed to own more than 3 percent of such a fund. In addition, a bank’s investments in such a fund couldn’t exceed 3 percent of its capital.

Before Congress passed the financial regulatory overhaul, banks had no limit on how much of those funds they could own. Still, typically on Wall Street, such investments already fall below the 3 percent threshold.

Banks could still put their clients’ money into those funds. They will still be able to manage such funds, and collect fees and a percentage of trading profits.

Public Comment Until January 13, 2012

The document is 298 pages, and although I am not going to read it here is a link to the Volcker Rule Proposal courtesy of the Wall Street Journal.

The Journal discusses the legislation in Regulators Unveil ‘Volcker Rule,’ Seek Comment

U.S. bank regulators on Tuesday unveiled for public comment proposed regulations that outline how banks should restructure their operations to comply with a new ban on risky speculative bets.

Under the so-called Volcker rule, banks would have to stop any proprietary trades by July 21, 2012, and would be barred from using foreign affiliates to conduct trades. They would have a two-year transition period to unwind their holdings of investment firms that conduct prohibited proprietary trades. Under the proposal, proprietary trades are defined as those lasting 60 days or less. For most shorter-term trades, banks would have the burden of justifying to regulators that such a trade is permitted.

In the complex, 298-page proposal, regulators posed 383 questions to industry groups and other members of the public for comment.

The proposal is designed to prohibit trades designed to make a quick profit, but critics say the exemption for hedging could allow banks to make the type of bets the rule aimed to prevent. That is because a bank might define the risk to its portfolio broadly, such as the risk of a recession. Regulators say a thorough compliance program will make sure that banks don’t make proprietary trades under the guise of hedging.

Proprietary-trading desks at banks have functioned like hedge funds, making bets on stocks, commodities and other assets, often using borrowed money to do so. A report by the Government Accountability Office in July said stand-alone proprietary trading accounted for $15.6 billion in revenue at the six largest bank holding companies for the 13 quarters from June 2006 to December 2010. However, proprietary trading accounted for $15.8 billion in losses, during the financial crisis wiping out the gains of the previous 4 1/2 years.

Fractional Reserve Lending and Fed Policies at Root of Crisis

Were it not for fractional reserve banking, sweeps, use of 20-1 leverage or greater, and the Fed keeping interest rates too low, too long, reckless behavior might not have happened.

Were it not for too-big-to fail policies of the Fed and Congress, banks may also not have engaged in reckless behavior.

To the extent banks do take poor risks on proprietary trading, on real estate loans, on credit cards, or anything else, they should be allowed to fail, not propped up at taxpayer expense.

Whatever this regulation achieves in its final form (good, bad, or nothing at all), it is 100% guaranteed to not address the root cause of the great financial crisis.

I would rather see bills to end the Fed and fractional reserve lending right along with it. Instead we have a 298 page proposal that addresses a symptom of the problem instead of the problem.

Mike “Mish” Shedlock
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