02/26/2012 10:13 pm ET Updated Apr 27, 2012

The Volcker Rule: Return to Sender

Paul Volcker deserves better. In the hands of Tim Geithner's Treasury, the Rule named for Volcker supposedly limiting speculative mischief by government-guaranteed banks is fast becoming a cumbersome parody of itself.

Financial regulatory officials, at the behest of Wall Street, have turned a simple bright line into a convoluted monstrosity. The questionnaire alone, inviting comments, runs 530 pages.

The bankers and their allies in government have succeeded once again in making their financial engineering too complex to regulate. The Volcker Rule, in the spirit of the 1933 Glass-Steagall Act, was supposed to simplify matters. But the regulators are helping Wall Street by adding to the complexity. See Jesse Eisenger's analysis from Propublica.

The capacity of Wall Street to create new mutations of derivatives that are not quite explicitly covered by this or that sub-sub-sub rule is of course endless. In the absence of a clear line, Wall Street can always field more lawyers than the government can spare regulators, and what an awful waste of taxpayer money.

It reminds you of Mad Magazine's Spy vs. Spy, an infinite regress of move and counter-move, giving regulation itself a bad name and providing fodder for Wall Street Journal editorial mockery.

Unless the Treasury and the other agencies reverse course and drastically simplify the regulation, Volcker should return the Rule to sender and refuse to have his still honorable name attached to this travesty. Better to call it the Geithner Rule.

The back story: In the infighting of late 2008, President Obama's incoming economic team of Larry Summers and Tim Geithner marginalized Volcker as a senior official of the new administration, despite the fact -- no, because of the fact -- that Volcker had been one of Obama's earliest supporters and understood the dynamics of the financial collapse far better than either of them. They gave Volcker a ceremonial advisory position with no real power. Volcker was a menace because he was counseling more constraints on bank powers than Summers and Geithner wanted.

It speaks volumes about this administration that the most radical person in the room on the subject of banking reform was usually the former chairman of the Federal Reserve.

Then in early 2010, Scott Brown stunned Washington with his upset win of Ted Kennedy's former Massachusetts senate seat. The White House political team desperately needed a populist pivot and an emblem of tough financial regulation. Obama quickly sent for a surprised Volcker, who had never before been in the role of populist (but then everything is relative.)

The White House, using Volcker as a prop, conjured up a "Volcker Rule," in the spirit of the Glass-Steagall Act (which Summers and Geithner in their Clinton-era roles had helped repeal). Despite Volcker's gracious endorsement, the proposed rule was not as elegantly simple as Glass-Steagall, or as tough as Volcker's own counsel.

The thrown-together Rule was vague; it did not propose to separate investment banking from commercial banking. It constrained but did not entirely prohibit proprietary securities trading by government-guaranteed banks. By the time the industry got through with its legislative lobbying, the version that passed Congress as part of the Dodd-Frank Act was tough in principle but left room for mischief in the administrative rule-making.

As Joseph Stiglitz and Robert Johnson observe in a letter to the regulators that is must-reading if you care about this stuff:

To the extent the Volcker Rule is too complex, that is at best a reflection of the incredible complexity that banking itself has created, and at worst a reflection of the proposed rule's timidity: it attempts to protect the complexity of the status quo and implement a law that directs a reduction of trading by banks without reducing trading by banks or trading overall. These contradictions must be rejected. For the U.S. to rebuild a healthy financial system -- one where savings go to productive investments, and the returns go back the investors -- the Volcker Rule's mandate to reduce bank involvement in complex trading activities must be implemented. Naturally, banks are resistant to these demands because they have taken refuge in complexity to extract massive margins and fees that generate bonuses, while avoiding the harsh sunlight of competition and the risk-reducing incentives of the threat of failure.

Or as Paul Volcker himself declared, in his own comments on implementation of the rule that bears his name:

In essence, proprietary trading activity, hedge funds, and equity holdings should stand on their own feet in the market place, not protected by access to bank capital, to the official safety nets, and to any presumption of public assistance as failure threatens.

Amen. Most of the financial engineering that caused the collapse was not about innovation to improve economic efficiency. New creations such as collateralized debt obligations or credit default swaps had two core purposes -- to disguise the real amount of hidden leverage and risk; and to protect outsized bank profits from the sunlight of real competition.

There is no good reason to allow a commercial bank to trade for its own account. The bank is likely to trade on inside information, creating a blatant conflict of interest between the bank ands its customers, as well as a moral hazard that the bank's extreme leverage will put the larger economic system at risk -- in just the way creation and trading of opaque derivatives caused the collapse.

How, after all, did the banking system function without these innovations, which only date to the 1990s? Answer: with a lot more efficiency, more modest profits for bankers, and far less potential to wreck the rest of the economy.

What the banking system needs now is drastic simplification. Commercial banks should take deposits and make loans. Investment banks, risking only their own money, should underwrite securities. Anybody who wants to gamble in securities trading should not also enjoy the privileges of being a banker.

The great unfinished remedial business of the post-crash reform is to study which innovations, if any, are worth keeping and how to carry out the overdue simplification of the financial system. The original Glass-Steagall Act ran only 37 pages. Investment banks and commercial banks were strictly separated, end of story. A properly fashioned Volcker Rule should be just that straightforward. Back to the drawing board.

Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is A Presidency in Peril.