Is the Volcker Rule in the Cross Hairs?

The Issue:

On February 3 President Trump signed an executive order directing the Secretary of the Treasury to report within 120 days on, among other things, the extent to which existing laws and regulations affecting American financial markets are “efficient, effective, and appropriately tailored.” A key regulation that is likely to be considered is the so-called “Volcker Rule” which was part of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule, named for former Federal Reserve Chairman Paul Volcker, was introduced to prevent banks from taking excessive risks and to reduce the likelihood that public funds would be needed for bank bailouts.

Critics say the rule imposes a heavy burden on banks and does not address the root causes that led to the Great Recession.

The Facts:

• The main purpose of the Volcker rule is to prevent banks from making risky investments that could endanger their solvency and put the stability of the financial system at risk. The rule prohibits banks from doing proprietary trading — which is when banks buy and sell securities or other financial instruments seeking to profit based on the securities’ price movements— and also from operating and investing in hedge funds and private-equity funds. Part of the rationale for prohibiting these activities is that depository institutions may be willing to take bigger risks if the government insures deposits since insurance may reduce depositors’ incentive to monitor banks’ behavior and withdraw funds if banks are taking risky positions.
• The most basic functions of commercial banks are to collect deposits and to lend these deposits to borrowers. Since the Great Depression, banks’ deposits have been insured by the Federal Deposit Insurance Corporation. Deposit insurance plays an important role in stabilizing the financial system; without it, depositors have an incentive to withdraw all their money from a bank at the first sign of danger. This can spark bank runs and potentially lead banks to collapse because banks only keep a fraction of their assets in the form of reserves that they can use to pay depositors. In contrast, investment banks — which engage in underwriting and trading securities — do not receive federal deposit insurance.
• The lines that in the past separated commercial banks from investment banks have become blurred. The Gramm-Leach-Bliley Financial Modernization Act of 1999 allowed commercial banks to engage in activities that had only been allowed for investment banks, including underwriting and market making. Underwriting is the distribution of a newly issued security to investors.  Market making occurs when a financial institution stands ready to buy and sell existing securities from investors. This market making service makes financial markets “liquid”, in the sense that investors can purchase and sell securities at relatively low cost. The largest American financial institutions now engage in both underwriting and lending. For example, the four largest commercial banks (as of September 2016): JP Morgan, Wells Fargo, Bank of America, and Citibank, are all affiliated with underwriters that rank among the top six underwriters of corporate bonds.
• There is a fuzzy line between proprietary trading and market making. A market maker trading securities generates profit from the spread between the prices that they pay to buyers and the prices they receive from sellers. Gains from proprietary trading, on the other hand, will generally depend upon the overall direction of market prices. But it can be difficult to distinguish between market making and proprietary trading, especially if the proprietary trading takes place within a short time horizon.
• The financial crisis of 2007-2009, the worst since the Great Depression, was caused by a range of factors.  But proprietary trading by deposit-taking institutions does not appear to have been among the major causes.  The 662-page final report of the Financial Crisis Inquiry Commission does not include the words “proprietary trading”.  However, Volcker has argued that losses within large trading positions were a contributing factor for some of the most systemically important institutions.
• The Volcker rule may have some adverse consequences.  Recent research demonstrates that the Volcker rule has made bond markets less liquid in times of stress, presumably because of the lack of legal or even conceptual clarity around the distinction between market making activities and proprietary trading activities. Other research, however, has concluded that overall liquidity has not fallen in the post-Dodd-Frank period. Still, the possibility of reduced liquidity at times of stress is an important cost of the Volcker Rule as it is currently implemented. This cost must be weighed against the rule’s benefits.
• There may also be better ways to address the risks that the Volcker Rule is intended to address.  For example, bank capital requirements —the amount of their own equity (as opposed to deposits and other funds that are borrowed by banks) that banks have to hold – have increased since the financial crisis. These increases have been particularly large for the largest banks and for banks that hold significant trading-related assets. The buffer provided by bank capital help ensure that the first losses incurred in the event of trading reverses are borne by the banks’ investors and not by the federal safety net.