On December 10, five very tired agencies brought forth the Volcker Rule. On December 16, Zions announced a $380 million write-down of its TruPS CDO. On cue, most of the banking trade associations fired off a howitzer, demanding that the regulators promptly rewrite the CDO section to save community banks from the fate that befell Zions. On December 18, the agencies bowed a bit, but the banks were having none of it. What does this tell us about the Volcker Rule? Not only that complexity is a curse unto banks and their regulators, but also that trying to do too much to satisfy too many policy objectives at too many regulators leads to nothing but confusion. What’s so wrong with using prudential rules to curb risks, even big ones in some proprietary-trading activities and covered funds?

Let me try quickly to explain the TruPS CDO challenge, starting first with the acronyms and then descending into the Volcker vortex. TruPS are trust-preferred securities issued by banks before the crisis that combine debt and equity features yet once were treated as regulatory capital. Since the crisis, regulators distrust TruPS and they are not Tier 1 capital except at small banks granted limited exceptions under the Collins Amendment. TruPS CDOs are collateralized debt obligations consisting of the debt portions of the TruPS that made issuing them even more fun because of the structural leverage possible in the CDO.

Why the Volcker problem? The law bars banks from investing in “covered funds,” which Congress seemed to think means hedge funds and private-equity funds. Volcker advocates don’t like these funds because they think they do things banks shouldn’t do and that banks ought not to be allowed via the back-door to do them anyway. Already, the logic here is breaking down because hedge funds do lots that banks do – invest in government securities and other financial instruments, but somehow a bank taking these risks in concert with its clients scares policy-makers silly. And, going farther than Congress might have meant, regulators decided to define covered funds not just to get the obvious suspects, but also to get funds comprised of other investments.

As initially defined, the rule could have constrained funds holding many conventional loan-based obligations like mortgages, but the final rule clarifies that covered funds do not include those in which the fund investment is, for example, an MBS comprised solely of mortgages. However, structured funds, including CDOs still are largely prohibited and, thus, the TruPS outcry once lawyers read the final rule and realized how much trouble their clients might be in, especially as year-end accounting deadlines loom.

The reason regulators kept CDOs and other structured holdings in the Volcker Rule ban is right in one sense – these structures can be very risky as a lot of banks learned the very hard way. But, just like some hedge funds, these structures also consist largely of assets a bank may hold directly. Banks large and small can hold CDOs directly – the poison apparently seeps in when the risk is borne in an equity position in a fund investing in CDOs instead of when the CDO is just plunked on the bank’s own books. This may well be embodied in rule, but its bearing on logic and effective prudential regulation escapes me.

When a bank holds a CDO or other asset, a phalanx of rules you all know well comes into play. Risk-based capital, risk-tolerance standards, liquidity rules, and overall safety-and-soundness standards are designed to curb risk and – one hopes – backed by supervisory scrutiny and meaningful enforcement. There are of course some holdings deemed too dangerous for policy reasons for U.S. banks – large equity stakes in manufacturing firms, for example. But, with the exception of a few clear prohibitions, U.S. law tries to handle risk through rules, not out-right activity prohibitions. The U.K. and European Union took one look at Volcker even before the final rule and also ran back into the arms of prudential regulation, not activity-by-activity sanctions, although they propose buttressing these with ring-fencing to limit the ability of risk migration in the universal-banking structures that characterize their systems.

In Volcker, we now have a regulatory paradigm in which risk is governed by naming names, not controlling risk. Perverse and unintended consequences, here we come.