



When Congress passed the Dodd-Frank Act to regulate the big investment banks so that a financial meltdown like the one we experienced five years ago “would never happen again,” a centerpiece of the effort was the Volcker Rule, named for former Fed chairman Paul Volcker. When Volcker initially formulated the rule, it was simple enough to fit on the back of an envelope: banks could not engage in “proprietary trading.” That is, banks could not hold and trade equities, for profit, on their own accounts. Banks were to be restricted to engaging in financial activities that served and profited clients. A simple rule. But alas, the world was not so simple. Banks had “legitimate” reasons to hold and trade equities. For example, there is “risk-mitigating hedging,” banks may need to invest in hedging instruments to manage the risks of their other financial transactions. Also, a bank may want to acquire securities not for itself but “in anticipation of customer demand”—to “make a market.” So exceptions would have to be carved out. What exceptions, and worded how? The lobbyists had a field day, and each of the five regulatory agencies involved has had a slightly different set of concerns. Years went by and hundreds of pages were added to Volcker’s simple idea. Now, at long last, the relevant regulatory agencies have agreed on a version of the Volcker Rule. The battle is not over, of course: there will likely be more lobbying efforts by banks, and even lawsuits. But at this point, it looks as though some version of the rule will be operative before too long.

When the Financial Stability Oversight Council began working on complexifying the Volcker Rule, Volcker was not happy. “I don’t like [the evolving rule], but there it is,” Volcker said. “I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance.” So why not just follow Volcker’s advice and promulgate clear and unambiguous rules?

Because there are no clear and unambiguous rules that can do the job. The problem is that the line between “prohibited activities” and “permitted activities” is faint and fuzzy, not bright and sharp. “Certain classes of permitted activities,” the Financial Stability Council wrote, “evidence outwardly similar characteristics to proprietary trading, even as they pursue different objectives.” Thus, to regulate financial activities in a way that allows banks to be banks, while protecting against future disaster, “rules and supervision,” said the Council, “should be dynamic and flexible.” “Dynamic and flexible” means good guidelines, rather than detailed rules.

So, will the current version of the Volcker Rule do the job? We don’t know how it will play out in practice (probably no one does), but we’re skeptical. In areas that are gray (like proprietary trading), no black-and-white rules are up to the task. Banks already have teams of very smart lawyers looking for loopholes—ways to honor the letter of the regulation but violate its spirit. Will these lawyers be successful? If past experience with regulation is any guide, the answer is yes. We have a tax code of astonishing complexity, with thousands and thousands of rules. Yet, somehow, loopholes continue to be found, saving the companies with the smart lawyers hundreds of billions of dollars annually in taxes. No set of rules is bullet proof. And the more specific the rules are, the more easily clever people will find a way to avert them.

What is the alternative to a detailed Volcker Rule? Aristotle had the answer. The alternative is good judgment on the part of the regulators—what Aristotle called “practical wisdom.” Practical wisdom combines the will to do the right thing with the skill to determine what the “right thing” is in situations that are often fraught with ambiguity. Thus, wise regulators are needed to internalize the aim of the rule—that banking activities should be for the ultimate benefit of the broader economy while maintaining the safety and soundness of the institutions. Only dedication to this North Star will give regulators both the energy and the doggedness to ferret out prohibited activities that are masquerading as permitted ones. Wise regulators also need the knowledge and perceptiveness to read each particular case. Interpreting whatever the rule turns out to be will demand regulators who are nuanced and discerning enough to figure out the intentions of the bankers and the potential consequences of their activities. And wise regulators also need to work inside institutions that will help protect them from the inevitable efforts of financial interests to capture them and their agencies. Sheila Bair tried to create such a culture at the FDIC. And so did Senator Elizabeth Warren, in setting up the Consumer Financial Protection Bureau. Detailed rules without wise regulators will likely fail. And with wise regulators, they will be unnecessary.

Banks don’t like the fuzziness of “guidelines.” They want the certainty of unambiguous rules so they can gauge the risks, predict the consequences of their business decisions, and no doubt, employ smart people to find ways around the rules, whatever they are. But no regulatory container is seamless, and if history is any guide, the big banks, like water, can usually find the cracks. The point of “dynamic and flexible” regulation is to enable regulators to find whatever “cracks” are being exploited by bankers, and seal them. That’s why we need to pay more attention to the hidden ingredient that might make the Volcker Rule work—wise regulators with the needed moral commitment and skill. Unless regulators have “practical wisdom,” even a thousand page version of the Volcker Rule will be inadequate to protect us from the next disaster. As Volcker himself said when his rule was first being discussed, “I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

Policy debates about how to prevent another financial meltdown have tended to ignore character and to focus instead on the two tools we always seem to turn to fix a broken institution—sticks and carrots. The sticks are detailed regulations designed to force bankers to serve their clients and the public good; the carrots are incentives designed to bribe them to do so. We develop long and detailed sets of rules in the hope that they will make good character unnecessary. But there is no set of rules—even a thousand pages long—that will do the job. We would all be better off if wise regulators used their judgment to apply guidelines wisely. Who knows: they might end up encouraging some bankers to become wise themselves. It is encouraging, in this regard, that the authors of the current Volcker rule have expressed the hope that it might change the culture of banking. Such a culture change is needed, but it will take wise regulators, not detailed rules, to make that happen.

This post was written with my colleague Kenneth Sharpe

Photo: Cynthia Johnson, TIME & LIFE Images / Getty Images