‘Long and Arduous Process’ to Ban a Single Wall Street Activity

At 6 feet 7 inches, Paul A. Volcker struck an imposing figure as chairman of the Federal Reserve during the economically turbulent 1980s.

But the banking rule named after him, approved on Tuesday, may not have the same sway over an unwieldy global financial system.

Five years after the financial crisis, five federal regulators agreed on a final version of the Volcker Rule. Its chief intention is to prohibit regulated banks from using customer money to trade for their own gain.

In many ways, just getting the rule done was an important milestone in the authorities’ efforts to overhaul the financial system. For starters, the rule was particularly taxing to write. It had to distinguish between trading that banks are allowed to do — to serve their customers and offset their own risks — from the prohibited trading done solely for their own profit.

At the same time, the regulators had to contend with a spirited lobbying effort by the banks, which argued that the rule was too severe and could end up constricting the flow of capital through the economy.

Mr. Volcker, not one for public niceties, sounded somewhat satisfied with the final rule. “In a long and arduous process,” he said in a statement released on Tuesday, “the agencies have dealt comprehensively with thousands of particular conceptual and practical questions raised by affected bankers, by legions of lobbyists, by other interested parties and by the general public.”

But the Volcker Rule’s biggest tests may be just around the corner.

The rule has plenty of potential gray areas that banks may be able to exploit. As a result, regulators will have to remain extremely vigilant, and understand highly complex trading books, if they are to properly enforce the rule.

Janet L. Yellen, who is poised to become the chairwoman of the Federal Reserve, recognized this challenge on Tuesday. “Supervisors are going to bear a very important responsibility to make sure the rule really works as intended,” she said at the Fed board meeting to approve the rule.

The regulators will have to learn Wall Street’s ways. Traders who make bets for the bank’s own gain, for instance, have often worked alongside traders who serve customers. As a result, it may be extremely difficult for examiners to decipher which trades are for clients and which are not.

“You could have a trading blotter that contains thousands of trades a day, and figuring out what goes with what could be difficult,” Matt Dunn, a director at Deloitte & Touche, said.

Still, the rule’s supporters argue that it will benefit the financial system in crucial ways.

In particular, they contend that the Volcker Rule will help prevent banks from building up outsize positions in securities and derivatives that could become of the source of debilitating losses when markets are swooning. In 2008, banks suffered gigantic hits on bonds and other instruments that they, in theory, held to meet customer demand.

Of course, the Volcker Rule still allows banks to stockpile assets for clients, known as market-making, but the regulation requires the banks to tie the size of such inventories to demonstrable levels of near-term customer demand.

As a result, proponents of the rule believe inventories of stocks, bonds and derivatives are likely to be leaner, reducing the probability that they will be the source of large losses. In fact, in recent years, as banks have prepared for the Volcker Rule and adopted other post-crisis regulations, Wall Street’s inventories have shrunk considerably.

But as memories of the 2008 meltdown fade, bloated, high-risk balance sheets may return. And on its own, the Volcker Rule may not be tough enough to stop banks from adding excessive amounts of risky assets, under the guise of market-making.

For instance, the rule appears to allow banks considerable leeway in deciding the size of their inventories. This was revealed on Tuesday during an exchange at the Fed’s board meeting. A Fed governor, Jeremy C. Stein, asked Sean D. Campbell, one of the Fed’s economists, whether the Volcker Rule would allow a bank to take on a sizable amount of assets that are illiquid, meaning they do not trade frequently. Such a position might be hard to reduce in a short time, since near-term customer demand might be weak. Without willing buyers, such positions can also result in steep losses. Even so, if certain conditions were met, Mr. Campbell said that the bank could take on a substantial illiquid position and still be in compliance with the Volcker Rule.

“That is in the spirit of what a market maker does,” he said.

Supporters of the Volcker Rule also hope that it will help improve the culture of Wall Street. A bank that gets a large share of its profits from short-term trading gains may take on excessive risks, offering the prospect of lush pay to its traders. One way the rule gets at culture is to prescribe how traders are paid.

The rule says that trader compensation cannot reward “prohibited proprietary trading.” Some financial experts take that to mean that banks cannot pay traders a percentage of any gains they make. Instead, the experts argue, it means they can only get a discretionary bonus. In theory, such a change would remove some of the incentives to carry out proprietary trading. But others say the wording is vague enough that banks will still be able to set up unhealthy incentives for traders, perhaps spurring them to carry out what is, to all intents and purposes, proprietary trading.

Despite the hopes resting on the rule, it was never meant to deal single-handedly with the dangers posed by large banks.

It is just one regulation among many that came from the Dodd-Frank Act, which Congress passed in 2010. And the rule was a compromise of sorts, which was always going to limit its impact. After the crisis, the Obama administration did not want to break up banks and separate their traditional banking operations from their Wall Street entities, as occurred in the 1930s with the Glass-Steagall legislation. Instead, the Volcker Rule’s more modest aim was to simply extract a single Wall Street activity — proprietary trading — from banks that get taxpayer backing.

Sheila Bair, the former chairwoman of the Federal Deposit Insurance Corporation, said she believed the Volcker Rule became especially necessary once large Wall Street firms like Goldman Sachs became fully regulated banks in 2008 and thus enjoyed access to government support. Yet she said there might have been a simpler alternative.

“It might have been easier to restore Glass-Steagall,” she said. “But there wasn’t enough political support for that.”