U.S. banks will be barred in most cases from trading for their own profit under a federal rule approved Tuesday.

Five U.S. regulatory agencies voted on the so-called Volcker Rule, a major step toward preventing extreme risk-taking on Wall Street that helped trigger the 2008 financial crisis.

'The problem with what Paul Volcker intended is that it’s incredibly difficult to legislate, incredibly difficult to take his vague and noble ideas and put them into a hard and fast piece of legislation' - Felix Salmon

Congress instructed regulators to draft the rule under the 2010 financial overhaul law.

The rule seeks to ban banks from proprietary trading. It's a practice that has been lucrative for banks. In addition to banning trades for their own profit, the rule limits banks' investments in hedge funds.

The thinking is that banks that are back-stopped by government money should not be able to make extremely risky trades, including investing in mortgage-backed securities as they did in 2007 and 2008, bringing themselves to the point of ruin. 

Impact on profits

Critics say the rule could cut into bank profits to the tune of $10 billion US and banks have argued against the rule.

But it also could prevent banks from risky moves such as the "London Whale" scandal, in which JPMorgan Chase traders sold off a large number of derivatives at one time, distorting markets and costing the bank $6 billion. 

Felix Salmon, a financial blogger for Reuters, says the rule seems to make sense and is remarkably close to former Fed chair Paul Volcker's intentions.

"The problem with what Paul Volcker intended is that it’s incredibly difficult to legislate, incredibly difficult to take his vague and noble ideas and put them into a hard and fast piece of legislation," Salmon said in an interview with CBC's Lang & O'Leary Exchange.

He noted the "epic lobbying effort" agains the rules by the banks, which seemed to make headway until the London Whale scandal.

"At that point, Congress said ‘you want these to be carved out why? This is exactly what we’re trying to prevent’ and from then on in the Volcker side of the argument, as opposed to the bank side of the argument, seems to have had the upper hand," he said

At 70 pages, with an 800-page preamble, the Volcker rule is incredibly complex and will require a massive and expensive compliance effort. 

There is an exemption for proprietary trades when they are made to facilitate buying and selling investment for customers, but banks have to back those up with paperwork, which they claim will interfere with markets.

"It’s entirely possible that the amount of market-making and hedging in the market might go down. That’s not the end of the world," Salmon said.

The largest U.S. banks — those with $50 billion or more in assets— will be required to fully comply with the terms of the rule by July 2015. Other banks will have until 2016 to comply.

Royal Bank of Canada is expected to be the Canadian bank most affected by the rule, as it has a large U.S. trading operation.

The agencies voting for the rule included the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency.

Compliance programs

The biggest banks will also be required to have compliance programs approved by their boards and senior executives. Banks will have to begin reporting on the status of those programs starting next year.

The banks' CEOs also will have to certify in writing to regulators that the banks have strong processes in place to ensure compliance.

The rule "has the important objective of limiting excessive risk-taking by depository institutions," current Fed Chairman Ben Bernanke said in a statement.

Big banks had reaped huge profits by taking extraordinary risks. But when those trades went bad during the crisis — especially after a wave of mortgage defaults — many of these banks were on the verge of collapsing. Most survived only because the government rescued them with taxpayer-funded bailouts.

The big Wall Street banks lobbied strenuously against the Volcker Rule. They argued that the ban could prevent them from market-making on behalf of customers or limiting risks.

Drafting the rule became very complicated. Regulators found it difficult to identify what constitutes proprietary trading in a bank's day-to-day operations.

For example, banks often engage in market-making.

And then there's what's called portfolio hedging. That's when the bank makes trades on its own account to hedge, or offset, the risks of a broad investment portfolio — as opposed to the risks of individual investments. It can be hard for regulators to distinguish when market-making and portfolio hedging cross over into proprietary trading.

With files from CBC News