Ask the Expert: Jennifer Erickson on the Volcker Rule

Q: What is the Volcker Rule?

A: The Volcker Rule is a key pillar of Dodd-Frank, the financial reform law that Congress passed in 2010 to ensure that taxpayers aren't again forced into a position where they have to bail out our nation's banks. Dodd-Frank brought landmark reforms to protect consumers and ensure the safety and soundness of our financial system.

The Volcker Rule is named after Paul Volcker, a former Fed chairman who also advised President Obama on how to respond to the 2008 and 2009 financial crisis, and who was very critical of what he saw as excessively risky activities on the part of many banks.

Paul Volcker proposed a rule that seeks to end the practice of federally insured banks making certain risky investments. The Volcker Rule states that if a bank takes deposits-such as a schoolteacher putting money in his savings account or a small business with a checking account-then that bank is not allowed to engage in what's known as proprietary trading. Proprietary trading is when a bank buys and sells certain investments for its own profit, instead of its clients.

Q: Why do we need it?

A: Proprietary trading-or "prop trading"-adds significant risk to banks, and has two central problems. First, it could put a bank in a conflict of interest with clients. For example, in 2008, some banks sold products to clients, while at the same time their "prop desk" took positions on the opposite side of the same deal.

The second problem is that if banks are trading with their own money, they run the risk of losing that money. If these speculative investments turn bad, and if the losses are substantial enough, then the federal government-and the taxpayer-may have to step in to bail out the bank. We need to make sure that we are never again in a situation where we allow profits to be private and losses to become public.

Q: What needs to be done to strengthen it?

A: The Volcker Rule is due to come into effect in July 2012. But in February of this year, Federal Reserve Chairman Ben Bernanke suggested that this deadline might be missed as regulators are still working out the final details to this critical reform.

Regulatory agencies need to deliver a strong Volcker Rule-one that is not weakened by people lobbying against reform. Paul Volcker has said he'd like to see more clarity enforced by smart regulators. He wants to see a rule that clearly bans proprietary trading and makes a bank's board and chief executive responsible for compliance. The key thing now is to make sure this happens.