What is the Volcker Rule?
The Volcker Rule is a federal rule that prohibits American commercial banks and foreign banks that operate in the United States from using the deposits of customers for their own personal profit.
Banks are prohibited from conducting any investment activity with their accounts and also limit their dealings with covered funds and hedge funds. Banks are only permitted to trade when it is necessary or vital to run their business.
For example, offsetting foreign currency, they are however permitted to make a trade for their customers.
This rule is contained in section 619 of the Dodd-Frank Wall Street Reform Act of 2010. This rule is aimed at protecting the interest of bank customers and was birthed after the financial crisis which hit the United States in 2008.
To help understand what exactly the Volcker Rule is all about, it is important to know the history of the rule.
HISTORY OF VOLCKER RULE
This federal regulation is known as the Volcker Rule because it was proposed by the chairman of the board of Governors of the United States Federal Reserve system from 1979 to 1987 known as Paul Volcker.
He was the head of President Obama’s economic advisory panel from 2009 till 2011
Paul Volcker made the proposal of the Volcker Rule in 2009 when the country was submerged in a financial crisis which led to the accumulation of losses by the proprietary trading arm of the largest bank in the country.
Paul Volcker hoped that the rule will enable the nation to reestablish the divide that existed between investment banking and commercial banking. He proposed that banks in the United States be restricted from making speculative investments that were of no benefit to customers.
He blamed the financial crisis that the nation experienced in 2007 and 2008 on the speculative activities of banks. Volcker proposed that a ban be placed on proprietary trading by commercial banks.
His claims were on the fact that the banks during the world wide recession created excess cash as a result of the increased number of loans made. Basically, money is generated every time a loan is made.
The result of this was terrible as it doubled the amount of money in 7 years as well as debt.
This entailed placing a ban on commercial banks making use of the deposits of customers to trade and make gains for the bank.
Even though the rule was scheduled to be fully implemented on 21st of July 2010 as part of the Dodd-Frank Act, certain delays were experienced and it wasn’t launched until the 10th of December 2013.
A lawsuit was filed by community banks on January 24, 2014, regarding the provisions that concern specialized security. The regulation was revised and on the 21st of July 2015, it came into effect.
The approval of the final regulations that came to be known as the Volcker Rule was done by five important federal agencies namely: the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation and the Commodity Futures Trading Commission.
These five agencies also have the responsibility of implementing and overseeing strict adherence to the rule.
SPECIFICATIONS OF THE VOLCKER RULE
As stated earlier, the Volcker Rule does not permit banks to use their accounts for short-term proprietary trading of commodity future, securities and derivatives.
Proprietary trading is the directional bets made by a firm, for the account of the firm, with the resources of the firm and for the gain of the firm.
The controversial thing about this is that any loss incurred during this had to be paid for through the FDIC insurance with the taxpayers’ money.
The rule also prohibits insured depository institutions and banks from obtaining or retaining ownership interests in private equity funds or hedge funds except in certain stipulated cases.
The aim of this rule is to discourage banks from taking too many risks and this is to be achieved by banning them from making such investments with their own funds in order to increase profit, this is based on the belief that these investments are of zero benefits to the customers of the bank.
No matter how strict this rule appears, it still permits banks to continue market making, hedging, engaging in the activities of insurance companies, underwriting, act as brokers, agents or custodians, offer hedge funds and private equity funds and even trade in government securities.
All these services can be rendered by the bank to their costumer’s in order to generate profit.
But if it is discovered that engaging in these activities can lead to a conflict of interest, generate instability within the bank and the financial system of the United States or expose the bank to high-risk assets, then the bank is prohibited from engaging in the activity.
The rule permits banks to trade under two circumstances; first if it is necessary to run their business, then the bank can trade.
For example, they can trade to offset interest rate rush and also engage in currency trading to offset foreign currency holding. Secondly, the banks are permitted to make use of the funds of clients with the permission of the client to trade on behalf of the client.
The Volcker Rule also has levels of reporting requirements that must be met by the banks. The details of the covered trading activities of the bank will be disclosed to the banks via these reports.
The reporting requirements and compliance of small banks are less when compared to those of larger institutions.
Large banks are expected to implement a program that will ensure compliance with the rule also ensure that their programs are subject to independent analysis and testing.
The Volcker Rule is binding to everyone that works in the bank starting from the CEO to every other person down the chain of command.
They are all personally and legally liable if they do not comply with the rule.
THE NECESSITY OF THE VOLCKER RULE
The major reason why this rule came into existence was to prevent history from repeating itself like it did in the years of the financial crises which was believed to be caused by the activities of banks.
This rule was put in place to act as a check that would prevent banks from placing investment bets with depositors, which was insured by FDIC and backed by taxpayers.
This is why many banks were not in support of the rule and it took five years for the rule to be implemented.
During the course of these five years banks lobbied to prevent the enactment of the rule which would restrict them from engaging in activities that are profitable to them.
Furthermore, the rule was intended to erase the damage that had been done to the economy when the Glass Steagall Act was repealed by Congress.
The Glass-Steagall act allowed investment banks to be run privately and small companies that helped to raise capital through issuing debt and going public in the stock market could stay small without needing any regulation while charging high fees.
During the repeal, six mega banks increased their assets from 20% to over 60% GDP from 1997 to 2008.
This was because the repealing of the Glass-Steagall act meant that banks could use the reserve of depositor’s funds to earn for themselves without any form of regulations.
The access they had to capital in the depositors’ fund enables them to make money despite a thin profit margin.
This was done basically because the deposits of commercial banks were protected by FDIC unlike the deposits of investment banks. They could borrow money at a cheaper rate than any other person.
This unfair advantage that community banks had wasn’t favorable to smaller banks and as a result, big banks began to buy up the smaller ones. This whole move dealt a heavy blow to the economy because when these big banks got into trouble, the money of taxpayers was used to bail them out.
If the venture went well then the bank managers and stakeholders benefited, but if it didn’t go well, the taxpayers had to bear the brunt. This wasn’t good at all.
Something had to be done about it and that was why the Volcker Rule was needed.
The Volcker Rule creates a financial safety net that excludes any financially risky activity especially activities that are unrelated to serving the customers of the bank.
Prior to the implementation of the Volcker Rule, banks could carry out activities that benefitted the bank at the expense of the costumer but with the Volcker Rule, every market activity had to be geared towards serving customers rather than profiting the bank.
In addition, the Volcker Rule was needed in order to level the playing field between two agents. An example is ensuring that the bank doesn’t mislead the customers on the terms of a mortgage.
This rule provides the required economic stability and also ensures that there is no clash of interest between the banks and their customers.
The Volcker Rule has eliminated the casino (betting and spontaneous competitive activities) part of financial institutions and this will reduce the level of panic or financial anxiety felt and will also make any financial crisis easy to manage.
It is safe to say that the Volcker Rule was needed to create a banking safety net that will benefit the customers rather than the shareholders of the banks.
Under this regulation, it is impossible for the bank to make gains at the expense of the customers. If this wasn’t done, then the financial crisis will be a reoccurring thing in the economy of the nation.
HOW DOES THE VOLCKER RULE IMPACT YOU?
There are six various reasons why you should be interested in the Volcker Rule and the kind of impact it will have on you:
- Due to the Volcker rule, it is going to be almost impossible for banks to need huge bailouts, such as the $700 billion bailout.
- Since the Lehman Brothers fallout, most bank customers would never want to experience such a thing again. With the Volcker Rule, this is less likely to occur. So it’ll save you from turning on the TV in the morning and seeing your bank is out of business.
- Before the Volcker Rule major banks were capable of using certain shady hedge funds to boost up their profits, however, after the Volcker Rule, it will no longer be possible for such to occur.
- You can sleep better at night because you’re certain your deposits are secure. This is due to the restrictions on banks, preventing them from gambling it.
CRITIQUES OF THE VOLCKER RULE
There have been numerous criticisms of the Volcker Rule from different sides.
For example, in 2014, the United States Chamber of Commerce claimed the benefits of the Volcker Rule are in pale in comparison to the costs it incurs. According to them, this occurs because a cost-benefit analysis was ignored.
What’s more, in 2017, a top risk official of the International Monetary Fund (IMF) revealed that restrictions with the aim of stopping speculative bets are quite difficult to ensure.
In addition, the IMF stand was that the Volcker Rule had the potential to unintentionally negatively affect bond market liquidity.
Backing up the International Monetary Fund criticism, the Federal Reserve’s Finance and Economics Discussion Series (FEDS) provided an equivalent critique, stating that due to the Volcker Rule, liquidity will diminish as the resultant effect of market-making activities of banks.
The criticisms are overwhelming, the image below shows a portion of dealer inventory which was held overnight by dealers due to customer trades.
This particular inventory reveals the measure of the number of customer demands a dealer is capable of absorbing in order to facilitate customer trades.
Dealers who are willing to keep greater inventories can ensure more trades for their clients. However, the image above clearly shows that dealers possessed greater inventories in order to ensure client trades before the Volcker rule and these inventories have gradually been declining.
As these inventories fall, dealers are probably going to initiate buy-and-sell order. This ultimately makes it hard for clients to revise their investment portfolios when the need arises.
Criticisms have been made, that the fall of dealer inventories are a result of bank regulation which is affecting market liquidity and inventory behavior.
First, they state that the revealed inventory decline is centered with bank-affiliated dealers, which shows that heightened bank regulation like the Volcker rule has a hand in it and that the fallout isn’t just due to large market-wide changes.
Second, they reveal that these falls are often the greatest during the Volcker era, which is dated to April 2014 to October 2016. These findings have suggested that the Volcker Rule is a major contributor to the fall of market liquidity.
The critiques keep pouring in as a recent report stated how the European Union had put an end to a drafted law which was taken by many as the reaction of Europe to the rule, with the no possibility of an agreement in the future.
Other reports have also revealed that after the Volcker Rule’s enactment, its impact on the revenue of major banks is less than expected.
However, certain current development in the implementation of the rule has the ability to affect operations in the future.
PRESENT STATE OF THE VOLCKER RULE
Due to the tough restrictions of the Volcker Rule, there are currently certain steps being taken to ensure that some of these restrictions are lifted.
This is in a bid to ensure that the complications of the rule are eliminated, as the rule covers over a 1000 pages.
In line with the 2017 recommendation of the Treasury Secretary Steve Mnuchin, Sen. Mike Crapo who is the head of the Senate Banking Committee sponsored a Senate bill which would push back certain portions of the Dodd-Frank law.
This is inclusive of the exemption of the Volcker Rule of banks with assets lower than $10 billion in the United States.
What’s more, changes have been pouring in from the commission responsible for enacting the law.
The five-member committee which includes the Federal Reserve, the Federal Deposit and Insurance Corporation, the Securities and Exchange Commission, the Treasury Department and the Commodities Futures Trading Commission.
As of May 30, 2018, a vote was passed by the Fed, to provide banks with a “compliance relief”. Banks are permitted to trade for their individual goals.
However, it’s tough for regulations to discern whether trades are speculative or not.
When the Volcker Rule was in full force, banks were forced to provide evidence that a trade was not speculative.
But now, the proposal by the Fed’s demands regulators to provide evidence that a particular trade is speculative.
What this does, is transfer the burden from off the banks to the regulators. All other committee members would be expected to fall in line with the Fed’s vote.
Banks are pushing for restrictions to be lowered as they want to carry out trades that run for anything lower than 60 days.
However, with the regulations of the rule, banks must tender evidence that the trades being run are for their clients.
Also, they want the exemption of certain overseas funds from the Volcker Rule, as well as reduced limitations on trading due to their wealth management plans.
WHERE IS THE VOLCKER RULE HEADED?
United States President Donald J Trump, in February 2017, passed an executive order which directed, Steven Mnuchin, the Treasury Secretary at the time to carry out a review on the present financial system regulations.
Due to the executive order, the Treasury has released numerous reports offering proposed changes to Dodd-Frank; this includes a recommended proposal aimed to permit banks to have more exemptions from various aspects of the Volcker Rule.
In June 2017 one of the statements released by the Treasury stated that it recommends major changes to the rule while adding that it isn’t for the repeal of the rule and only “supports in principle” the Volcker rules restrictions on proprietary trading.
This was the report which notably recommended the exemption of certain banks with assets lower than $10 billion.
The Treasury as well stated the various regulatory compliance difficulties initiated by the Volcker rule and proffered solutions for refining and simplifying proprietary trading definitions and covered funds.
In addition, the softening of the regulations as well in order to permit banks to efficiently hedge their risks.
So where will this place the Volcker rule in the future? Well since this assessment in June 2017, Bloomberg reported at the start of 2018, that steps to revise the rule has been taken by the Comptroller of the Currency in turn with certain recommendations of the Treasury.
However, there are no definite timelines for when these revisions would take effect. Nevertheless, such revisions could probably take years to implement.
Furthermore, the Federal Reserve Board vote at the end of the month of May in 2018, opened for door wider restructuring of the Volcker rule as it is presently.
The Volcker rule initially aimed at protecting customer funds in banks has in recent years met some very tough resistance. This has been due to recommendations from various committees responsible for it.
The purpose of these recommendations has been to lower the strict regulations on banks, restricting them from certain trades, with proof exemptions on other types of trades.
A lot of the recent happenings point towards the relaxation of the rule in the near future, as there seems to be overwhelming evidence of its negative effect on market liquidity as well as problems with its cost to benefit analysis.
Regardless of the number of criticisms, the Volcker rule generates mixed opinions in the financial sector. The big banks lobby to see certain aspects of the rule taken off as they state it hampers on profits.
However, irrespective of the point of view of the rule it is no doubt a hot issue in the financial sector.
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