This week saw a deluge of comment letters flooding into the regulators on the Volcker Rule. Now, the hot potato is back in the hands of the regulators – none of whom asked for it – and the Congress – which first perpetrated it and now, despite second thoughts included in some comments, wants little to do with fixing it. It remains to be seen what the agencies will do with this devilish standard, but some of the industry letters raise not only the anticipated cost and competitiveness concerns, but also important complexity-risk considerations. These arise from the collision of the proposal’s demands with the need for banks to use banned activities to hedge risk. In essence, the proposal seeks to cure one risk – the putative one resulting from proprietary trading – by barring proven forms of risk management, leading to a downward spiral of less trading but still more risk.

For a clear explanation of why the proposal poses unanticipated problems, look no farther than the letter filed by a group of regional banks – not little guys, but still not the behemoths targeted by Mr. Volcker and his eponymous rule. In fact, it’s precisely because these regional banks aren’t behemoths that the Volcker Rule hits them squarely in the face. One of the most problematic contradictions in the Volcker Rule lies in the difficulty of conducting effective, risk-hedged asset-liability management (ALM) and, at the same time never trading in anything but USG and agency obligations. This is hard for all banks, but especially so for those without the huge risk-management and market operations housed in the very largest U.S. banks.

Congress in fact anticipated the hedging problem and told regulators not to ban proprietary trading if it is part of risk hedging. However, the proposal takes a puritanical view of hedging, essentially banning any trading that a bank might use as a hedge if it doesn’t meet the rule’s sumptuary standards. These are threefold: the hedge must be placed at about the time a risk is taken, the bank may not profit from the hedge and, even if these stiff standards are met, the trade must still be scrutinized by examiners to ensure it isn’t disallowed.

Longstanding hedging practice – at least at effective risk managers – is first to hedge on a portfolio basis, not deal by deal. One would think regulators would applaud this, as it provides broad risk coverage on a forward-looking basis without the cost of transaction, operational and other risk resulting from deal-by-deal hedging. Good hedging also can be profitable – in essence, the better you do it, the better the hedge performs. So, sniffing at profits when these are a side-effect of a hedge also creates a perverse result – only poor-quality hedging that doesn’t earn a nickel may occur. And, finally, hedge-by-hedge scrutiny from examiners may lead institutions to avoid any hedging that isn’t risk-by-risk or that could be profitable, essentially resulting in reduced risk hedging to prevent post hoc supervisory sanction. To control legal and reputational risk, banks will manage ALM to meet the rule, not to hedge the risk.

The details of the NPR also strangle hedging in other areas. We’ve noted before the inherent contradiction between the strict treatment of trading done for liquidity-risk management purposes in the NPR with the broad push for enhanced liquidity in the Basel III standards. As proposed, only proprietary trading in the trading book is a permissible hedge, thus essentially telling banks they may not trade to hedge liquidity risk in the banking book – where, of course, there are loads of liquidity risks which Basel III aims to cure. In the liquidity-risk context, regulators like lots of assets – including high-quality non-U. S. sovereigns. But, for Volcker, these unencumbered liquid assets are verboten.

The perverse impact of the NPR on ALM risk hedging and thus, on a vital prudential goal is only one result of the complex NPR. No matter how valid the Volcker Rule’s premise – that banks should not make “speculative” bets with depositor’s money – the details of the proposal pose a wide array of unintended consequences with far-reaching and, we think, unintended implications.

This brings us back to our simple solution to complex regulatory problems: provide a few clear, measurable standards in rule and then hold both banks and examiners responsible for meeting them. In the Volcker context, this would mean setting a clear, simple standard that says what the law says – banks may trade in an array of obligations to hedge risk across their risk profile. Then, risk-management, compliance, auditors, senior management and the board should look to see if, in fact, trading is only for hedging based on measurable, clear standards of what’s a hedge and what isn’t. Risk managers know which is what and, if appropriately independent from profit-making business operations, they’ll say so. If they don’t, the bank has a far bigger problem than those the Volcker rule seeks to curb.

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