INTRODUCTION

Section 619 of the Dodd-Frank Act, known as the Volcker Rule, sets prohibitions, requirements, and limitations in relation to the trading and private fund activities of banking entities and systemically risky nonbank financial companies. The Volcker Rule is wide-ranging and complex, with activities that are permitted despite the prohibitions and many elements that are subject to rulemaking and interpretation. In this chapter we explore the Volcker Rule in-depth.

After you read this chapter you will be able to:

• Explain the Volcker Rule.
• Understand the Volcker Rule's motivation and objectives.
• Describe the Volcker Rule's prohibition of proprietary trading by banking entities.
• Describe the Volcker Rule's prohibition of ownership or sponsorship of hedge funds and private equity funds by banking entities.
• Explain the impact of the Volcker Rule on systemically risky nonbank financial companies.
• Describe activities that are permitted despite the Volcker Rule.
• Understand how the Volcker Rule was implemented.
• Explain criticism of the Volcker Rule.

INTRODUCTION TO THE VOLCKER RULE

The “Volcker Rule” is the commonly used title of Section 619 of the Dodd-Frank Act. Section 619 is referred to as the “Volcker Rule” in recognition of Paul Volcker, a former chair of the U.S. Federal Reserve and the driving force behind Section 619. Specifically, Paul Volcker had chaired a Group of Thirty Steering Committee that formed recommendations in response to the credit crisis of 2007–2009. The resulting report, which was largely authored by Volcker, includes recommendations that formed the basis of the Volcker Rule.¹

The Volcker Rule prohibits banking entities from engaging in two broad types of activities. First, the Volcker Rule prohibits banking entities from engaging in proprietary trading, in which the banking entity trades for its own account to generate short-term profits. Second, the Volcker Rule prohibits banking entities from owning or sponsoring hedge funds and private equity funds. The Volcker Rule also sets limits and requirements for systemically risky nonbank financial companies engaged in these activities. We will discuss the Volcker Rule's prohibitions, limitations, and requirements in more detail in the next section.

The motive behind the Volcker Rule is straightforward: Banking entities and certain other financial companies are crucial for the U.S. economy, and are supported and insured by the U.S. government in various ways. But this backing can lead these entities to engage in activities without guarding sufficiently against the associated risks. Effectively, the entity engaging in the risky activities will benefit if the activities prove profitable while the U.S. Government bears the costs should the risky activities lead to distress, a situation referred to as “moral hazard.” In a statement to the U.S. Senate's Committee on Banking, Housing, and Urban Affairs before the passage of the Dodd-Frank Act, Paul Volcker described the challenge as follows:²

The basic point is that there has been, and remains, a strong public interest in providing a “safety net”—in particular, deposit insurance and the provision of liquidity in emergencies—for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds—taxpayer funds—protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions.

The purposes of the Volcker Rule are threefold, as noted in an implementation study performed in 2011 by the Financial Stability Oversight Council (FSOC):³

1. To separate federal support for the banking system from a banking entity's speculative trading activity
2. To reduce potential conflicts of interest between a banking entity and its customers
3. To reduce risk to banking entities and nonbank financial companies that are regulated by the Federal Reserve

It is useful to recognize that the Volcker Rule is the latest evolution in the approach of U.S. policymakers in response to moral hazard concerns and concerns about how the activities of banking entities can threaten financial stability. The Banking Act of 1933, commonly known as the Glass-Steagall Act, separated commercial banks and investment banks and created the Federal Deposit Insurance Corporation (FDIC), which provides deposit insurance. The Glass-Steagall Act was a response to the stock market crash of 1929, the Great Depression, and extensive bank failures. Through separating commercial bank activities from investment bank activities, the Glass-Steagall Act hoped to protect commercial banks, and the U.S. economy, from losses driven by investment bank activities. Over the subsequent decades, interpretations and administrative rulings relaxed the separation of activities. This culminated in the Financial Services Modernization Act of 1999, known as the Gramm-Leach-Bliley Act, which repealed the separation of commercial banks and investment banks.

The Volcker Rule's approach is aligned to the approach of the Glass-Steagall Act. Senator Jeff Merkley noted in a statement that the Volcker Rule:⁴

…embraces the spirit of the Glass-Steagall Act's separation of “commercial” from ‘investment” banking by restoring a protective barrier around our critical financial infrastructure. It covers not simply securities, but also derivatives and other financial products. It applies not only to banks, but also to nonbank financial firms whose size and function render them systemically significant.

While the intent of section 619 is to restore the purpose of the Glass-Steagall barrier between commercial and investment banks, we also update that barrier to reflect the modern financial world and permit a broad array of low-risk, client-oriented financial services. As a result, the barrier constructed in section 619 will not restrict most financial firms.

THE VOLCKER RULE: DETAILS

The Volcker Rule prohibits banking entities from engaging in proprietary trading; prohibits banking entities from owning or sponsoring hedge funds and private equity funds; and sets limits and requirements for systemically risky nonbank financial companies engaged in these activities. In this section we will first explore these prohibitions, limitations, and requirements. We will then turn to activities that are permitted despite the Volcker Rule's prohibitions, requirements, and limitations.

IMPLEMENTATION OF THE VOLCKER RULE

The Volcker Rule instructed the FSOC to engage in a study and the formation of recommendations in relation to the Volcker Rule. The FSOC study, which was noted earlier in this chapter, was completed in January 2011. The FSOC made 10 recommendations, presented in Table 10.2.

The Volcker Rule also mandated that various financial regulators should engage in coordinated rulemaking to facilitate implementation. This resulted in the joint issuance on December 10, 2013, of the “final rules” implementing the Volcker Rule by the OCC, the FDIC, the Fed, the SEC, and the CFTC. The final rules, which consist of four subparts and two appendices, are extensive and complex, and include a rigorous compliance regime and reporting of quantitative measures for certain banking entities engaged in proprietary trading. For example, the final rules include careful definitions of proprietary trading, trading accounts, and financial instrument and clarify whether certain activities, such as repurchase agreements, are deemed proprietary trading. They also carefully define exempted activities and set the compliance and reporting requirements to take advantage of the exemption. The Volcker Rule took effect in July 2015.

VOLCKER RULE: CRITICISM

As explored extensively in this chapter, supporters of the Volcker Rule argue that it is necessary to reduce the risks to which trading activities expose banks and systemically risky nonbank financial companies, as well as financial stability. Yet many others argue that there is reason to question whether the Volcker Rule will succeed. Let's explore some examples of criticism of the Volcker Rule.

Cornell Law School Professor Charles Whitehead argues in a Harvard Business Law Review article that the Volcker Rule fails to sufficiently take account of change in financial markets.⁶ Specifically, he argues that while the Volcker Rule prohibits risky trading by banks, it does not prohibit hedge funds from engaging in risky trading; hence, hedge funds may take over much of the activity from which banking entities are prohibited. But hedge fund activities can harm financial stability and banks that are exposed to the activities of hedge funds. Whitehead asserts:

By causing proprietary trading to move to the hedge fund industry, banks continue to be exposed to the same risks—perhaps less directly than before, but now in an industry also subject to less regulation If the regulatory concern is with proprietary trading, the question should not be whether banks are engaged in proprietary trading, but rather, whether banks and banking activities are exposed to the risks of proprietary trading. Today, the location of those risks extends beyond the banking industry, reflecting an evolving financial system and change in who is conducting bank-like activities. By failing to take that change into account, the Volcker Rule potentially results in new and costly regulation that increases risk-taking among less-regulated entities but may still affect banking activities.

Others criticize the Volcker Rule for other reasons as well. In a hard-hitting analysis prepared for the U.S. Chamber of Congress' Center for Capital Markets Competitiveness, finance professor Anjan Thakor argues the Volcker Rule will adversely impact bank customers and banks for four reasons. These include the Volcker Rule's negative impact on market making and liquidity provision; the harm to market-maker networks due to the retrenchment of banks in market making; higher cost of capital to borrowers due to reduced liquidity and regulatory uncertainty; and the damage to bank risk management due to the Volcker Rule's constraints on the types of securities that banks can hold.

There is no immediate resolution of the debate as to whether the Volcker Rule meets its objectives, has no impact, or is harmful. The Volcker Rule's complexity, the wide range of stakeholders, and the usefulness of arguments for and against the Volcker Rule by politicians wishing to take populist positions means that the debate is likely to continue. More broadly, the Volcker Rule is the latest chapter in the evolving approach of U.S. policymakers in response to moral hazard concerns and concerns about how the activities of banking entities can threaten financial stability, and it is unlikely to be the final chapter.