The Volcker Rule

The Volcker Rule, named after former Fed-Chairman Paul Volcker, is Section 619 of the Dodd-Frank Wall Street Reform and Consumer Act. Dodd-Frank was a response to the financial crisis of 2007-2008. The role of Dodd-Frank was “to build a financial system that helps the real economy while also preventing future crises.” The Volcker Rule specifically attempted to restore “part of the firewall between commercial and investment banking,” which was lost in the repeal of Glass-Steagall. The Volcker Rule was implemented to prevent banks from making “large speculative bets” and to refocus the bank’s attention to serving customers. The Volcker Rule and Dodd-Frank were important pieces of legislation, implemented to create a stable banking sector.
The Volcker Rule prohibits banks with over $50 billion in capital from the short-term proprietary trading of securities, derivatives, futures, and options. The Volcker Rule also prohibits banks from owning more than 3% of hedge funds and private equity funds. The Federal Reserve, the FDIC, the Office of the Comptroller of the Currency, the SEC, and the CFTC have specific roles in regulating the Volcker Rule. All banks, to which the rule applies, needed to comply with the Volcker Rule by July 2015.
The Volcker Rule’s legitimacy has been debated since 2010 when Dodd-Frank was enacted. The primary debate surrounds proprietary trading; trading “for [a banks] own direct gain instead of earning commission dollars by trading on behalf of its clients.” The Volcker Rule does not prevent banks from market making, hedging, securitizing, and underwriting. But, the line between proprietary trading and market making or hedging can be blurry.
Charlie Munger, Warren Buffett, and Michael Lewis have been vocal advocates of the Volcker Rule and argued that removing a bank’s proprietary trading desk will reduce banking risk. Paul Volcker addressed many of the arguments against his rule. Volcker argued proprietary trading is an important risk factor, though he admits proprietary trading alone did not cause the financial crisis. Additionally, trading losses can be so large that banks require government assistance. Volcker said, “Losses within large trading positions were in fact a contributing factor for some of our most systemically important institutions, and proprietary trading is not an essential commercial bank service that justifies taxpayer support.” Volcker believes that banks engage in overly risky proprietary trading because the FDIC and Federal Reserve, acting as a lender of last resort, can assist the bank.
Matthew Richardson from NYU also argued for the separation between proprietary trading and commercial banking. Richardson believes access to the Federal Reserve and FDIC should not be granted to an investment bank. Richardson said, “Limiting government guarantees to core banking activities and segregating nonbanking risk-taking businesses,” is in the public interest. The inherent risk of proprietary trading is, according to Richardson, placed on the taxpayer. Ultimately, Richardson wants banks to “internalize the costs of systemic risk that they produce” from proprietary trading.
Volcker addressed several additional concerns of the Volcker Rule. Many opponents of the Volcker Rule argued the rule would make US firms less competitive compared to their international counterparts. According to Volcker, when banks participate in market making and maintain proprietary trading desks within the same firm, there is a conflict of interest. Proprietary trades can conflict with customer orders. Volcker believes customers will reward banks that complying with the Volcker Rule because there will be no conflict of interest and customers will appreciate commercial banks acting as banks, not traders.

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Ultimately, Volcker wanted commercial banks to focus on serving the customer before growing bank capital through proprietary trading. Many opponents to the Volcker Rule question the impact of proprietary trading on the 2007-2008 financial crisis. Ben Steil from the Council of Foreign Relations was one vocal opponent. Steil cited “excessive origination, [and] purchases and leveraging of low-quality mortgage assets” as causes for the financial meltdown. Steil continued his argument by claiming the Volcker Rule would not have prevented the recession. “The notion prop trading is inherently riskier or subject to greater realized losses than plain old lending, as we saw in 2008, is flawed,” stated Tyler Cohen of Fisher Investments. These opponents additionally cited that removing speculative trading from highly regulated banks would only push those activities toward less regulated firms.

The blurry lines between proprietary trading and market making or hedging have been a major point of contention. Mike Konczal of The Washington Post claims this distinction is the only real argument against the Volcker Rule. Steil claims purely speculative proprietary trading and risk-reduced hedging are two opposite ends of a spectrum, with the majority of trades somewhere in the middle. “A trade that is speculative on a Monday may become risk-mitigating by the following Friday,” according to Steil.

In September 2016, the Fed released a paper that analyzed the effect of the Volcker Rule on corporate bond liquidity. The paper concluded, “The net effect is that bonds are less liquid during times of stress due to the Volcker Rule.” The market making capabilities of banks were hindered and firms outside of the Volcker Rule’s jurisdiction filled the gap. According to the Fed, the opponents to the Volcker Rule like Steil and Konczal were correct and regulation pushed speculative behavior outside of highly regulated banks in addition to reducing liquidity.

Trump’s victory in the 2016 presidential election and hopes of deregulation has sent financial stocks soaring. “The Financial Choice Act, a key bill championed by House Financial Services Chairman Jeb Hensarling, calls for repealing the Volcker Rule.” But even without enacting new legislation, Trump can choose to not enforce the rule.

If the anti-regulation side is correct, the removal of the Volcker Rule will result in increased liquidity for firms and increased ability to perform market-making transactions. The ability of large banks to engage in proprietary trading could make the banking industry safer because large banks are regulated more than small hedge funds.

If the pro-regulation side is correct, the Volcker Rule is simply one piece of the puzzle needed to create a stable banking sector. They claim that if the rule was repealed or defunded by Trump, it would result in higher volatility in financial markets and another financial crisis because of the banking sector risk. Based on the model of fractional reserve banking, the implications of risky proprietary trading on a firm’s balance sheet is clear. Large losses in proprietary trading could devastate bank securities. Substantial losses in asset value could prove dangerous for banks and increase leverage ratios.

The debate over banking regulation continues. The costs and benefits of the Volcker Rule need to be fully understood in order for policy makers to completely grasp the scope of the rule. The Great Recession is still prevalent in the minds of politicians and bankers alike. The Volcker Rule is important because any mechanism that could prevent a future recession needs to be analyzed and tested in detail.