Just as banks breathed a little bit easier over the Volcker Rule, its author lobbed another blast at the biggest of the big: a limit on long-term investments (aka, merchant banking). At the outset, the industry largely discounted the prospects of the Volcker Rule, only to be surprised when Congress enacted a remarkably tough version of it. A similarly sanguine approach to what we’ll call Volcker II could lead to another round of unpleasant surprises, especially if Volcker II can, as the former Fed chairman suggests, be executed without new law under the ambit of Volcker I.

As is often the case in financial regulation, an outlier deal has sparked the outrage stoking Volcker II. It’s the Goldman Facebook transaction. Now withdrawn for U.S. investors, the deal sparked howls due to what we have to agree was a transparent effort to make some bucks with scant regard to applicable U.S. securities law. Carefully engineered to sidestep securities-registration requirements applicable to an initial public offering, the stock sale was that in all but name. Under the heavy breathing of all its critics, the legal edifice collapsed.

None of Goldman’s securities-law shenanigans has prudential implications other than with regard to legal and reputational risk. But, these days, legal and reputational risk pack a punch that, after bruising the perpetrator, can put a big shiner on the face of other large financial institutions. Since none is being seen in a particularly flattering light of late, the blow is particularly ugly.

Which brings us back to Mr. Volcker’s latest proposal. Volcker I goes after banks when they invest as principal in hedge funds and private-equity firms. Although Dodd-Frank provides some limited flexibility, the law is about as tough as Mr. Volcker could have wished, essentially pulling U.S. banking organizations out of what is both a lucrative and, potentially, a high-risk book of business.

In Mr. Volcker’s eyes, merchant banking poses the same risks because banks make investments as principals in ventures that have nothing to do with banking – Facebook, for example. In comments yesterday in the Financial Times, Mr. Volcker

suggested that merchant banking could in fact be riskier than the investments he successfully quashed because they are far longer in duration. He might have added, as surely he will going forward, that some merchant-banking stakes are less liquid than hedge-fund and private-equity investments, especially when funding is provided to firms that aren’t publicly traded or that have few third-party investors in their start-up mode. Closely-held firms can also be risky because of the strong role a founder or large investor can play, a situation to some degree analogous to the private-equity firms, although far less true with hedge funds under the securities laws (at least on their good days). In the FSOC set of recommendations on Volcker I, the rationale outlined for the ban on covered investments applies in many ways at least as clearly to merchant banking, although the issue is not discussed.

Of course, a bank’s ability to engage in merchant banking is not only defensible, but also enacted into law in the form of the Gramm-Leach-Bliley Act’s express authorization for it under the ambit of a financial holding company. Thus, a back-door evisceration of merchant banking through broad regulatory repeal under the guise of Volcker I is both of questionable legality and dubious probability. However, the Dodd-Frank Act does expressly authorize regulators to ban any activities otherwise permissible under the Volcker Rule that are otherwise deemed evasion or unduly risky. This is clearly the tent under which Volcker II would be housed – arguments that merchant banking deals, especially if seen as big or bad, are only private-equity investments absent the insulation of the PE firm’s own capital.

Could this happen? These days, nothing is off limits in the debate over cutting big banks down to the small size and the limited scope critics demand. But, Mr. Volcker has a particularly important ally on Volcker II; the FRB. The Fed was no friend of merchant banking when it was put into the Gramm-Leach-Bliley Act. In fact, the powers in the Act are far more limited than sought by the industry at the time (1999) because the Fed objected so vociferously to them. The FRB has a long-time stand against commingling banking and commerce that goes back before Mr. Volcker’s time as chairman and has largely stood fast since. Sparked by Mr. Volcker’s latest initiative, the Board – perhaps the most important Volcker I implementing agency – could well take another, unflattering look at merchant banking. Armed now with Volcker I, a Volcker II rule from the Fed could well reinstate the merchant-banking limits that the Fed lost the first time around.