On December 10,the much acclaimed Volcker rule was finalised by five US regulators the Federal Reserve,the Securities and Exchange Commission,the Office of the Comptroller of the Currency,the Federal Deposit Insurance Corporation and the Commodity Futures Trading Commission. The rule was part of the Dodd Frank Act,which was passed in the wake of the global financial crisis. There are similar initiatives in the UK (Vickers Commission) and the EU (Liikanen Report). While the latter two are yet to be translated into legislation,the hotly contested but crucial rule-writing process for the Volcker Rule has been completed after three long years of deliberation.

The genesis of these three initiatives in key financial jurisdictions lies in the attempts to reinstate a Glass-Steagall-type firewall which was in existence in the US since 1933,but repealed in 1999 by the Clinton administration between deposit-based and investment banking. Glass-Steagall restricted commercial banks,which had access to deposit insurance and liquidity buffers from the central bank,from underwriting or dealing in securities,and investment banks from accepting deposits. Like Glass-Steagall,the Volcker Rule is part of a slew of measures designed to maintain financial stability by insulating the critical economy-wide payments system from the kind of classic bank runs that haunted major advanced economies right up to the Great Depression,necessitating large taxpayer bailouts.

This firewall was successful in preventing major bank runs in the post-war period until it was overtaken by financial innovation and light touch regulation,which is based on disclosure rather than control. In retrospect,it is unsurprising that the collapse of this firewall led to the buildup of systemic risk in the financial system that boiled over with the run on Lehman Brothers,a systemically important,large investment bank.

The trigger for the crisis this time around was the shadowy investment,rather than depositary,arm of various banks. Fire-sales of assets led to prices spiralling downward. Shadow banks did not access a stable deposit base for funding,but volatile short-term capital. This became difficult to roll over as credit markets froze. Shadow banks are not cushioned by the liquidity buffers of deposit insurance and central bank discount windows,which can prevent a liquidity problem from escalating into a full blown bank run.

By seeking to limit proprietary trading (on the banks own account) unrelated to customer needs and limiting the ownership or sponsorship of hedge/ private equity funds to 3 per cent of Tier I capital,the Volcker Rule restricts the risky business activities of depository banks. This backtracking on universal banking is a major landmark in ongoing regulatory reform.

While the three models (Volcker,Vickers and Liikanen) will have to stand the test of another crisis to prove their efficacy,lingering concerns are already evident. The big question is whether the loss due to the passing on of the costs of regulatory restructuring and the shrinkage of assets to borrowers is commensurate with the gains in financial stability.

First,while Glass-Steagall prohibited an entity from undertaking both commercial and investment banking,the Volcker rule merely prohibits an entity that accepts public deposits from undertaking certain types of trades. Even as it prohibits proprietary trading,it allows hedging and market making. In practice,it is difficult for the regulator to distinguish between trades entered into for profit or for hedging,as financial innovation blurs such boundaries. The derivatives losses of J.P. Morgan caused recently by the London Whale highlighted this difficulty. Its CEO,Jamie Dimon,maintained before the US Congress that the trade was a hedge for its overall exposure. Would this trade have been disallowed under the Volcker rule? It is difficult to determine.

Second,the separation of banking from trading activities does not make commercial banking less immune to risky lending practices. The heart of banking lies in risk taking,and the biggest risk is credit risk. Every banker who buys risk into his balance sheet by extending a loan is within his right to seek options to mitigate the risk. Securitisation and derivatives are tools to do this. The problem lies not so much in these tools of risk mitigation as in credit assessment. If the underlying pool of mortgages were healthy cash flows secured through expected stable labour incomes rather than through speculative positions on volatile asset prices sub-prime defaults may have been contained,instead of boiling over on account of changes in monetary policy and the reversal in housing prices. Lax credit assessment and distorted compensation practices added fuel to the fire.

Third,would Glass-Steagall have prevented the financial meltdown of 2008? Institutions like Bear Stearns,AIG,Merrill Lynch,Goldman Sachs and Lehman Brothers,which all ran into trouble,were systemically important but not commercial banks. Deposit-taking commercial banks also had to be bailed out because of their holdings of the same illiquid securities through off-balance sheet investment vehicles. Investment in these securities was not restricted under Glass-Steagall. To the extent that the Dodd Frank Act empowers the Financial Stability Oversight Council to declare any financial institution including investment banks,hedge funds,etc systemically important and bring it within the regulatory perimeter,it does address the problem of unregulated too big to fail institutions. The problem is whether the Volcker Rule,and even Basel III,adequately firewalls depositary institutions against risks arising from shadow banking.

Lastly,the constructive ambiguities of the Volcker Rule constitute a legal minefield. Its an 882-page behemoth,appended to the gargantuan Dodd Frank Act,itself 828-pages long,to be implemented by five separate agencies. Compare this to the 37-page elegance of the Glass-Steagall Act. In the legal battles that shall ensue,pitting regulators against Wall Street firms,there is little doubt who will have the highest-paid lawyers and psychiatrists to prove intent on their side.

Sheel is secretary,Prime Ministers Economic Advisory Council. Ganguly is an independent researcher. Views are personal.