The Volcker rule is an important part of the banking sector that came after the Global Financial Crisis (GFC) as policymakers worked to protect customers from another collapse.
The rule was signed into law as part of the Dodd-Frank Regulations in 2010 by President Obama. This article will look at what the Volcker rule is and how it applies to the financial market.
History of the Volcker Rule
The history of the Volcker Rule can be traced in the 1930s after The Great Depression. At the time, the banking system was relatively unstable, with many banks collapsing.
To solve the crisis, President Franklin Roosevelt signed into law the Glass-Steagall Act, which separated commercial banks from investment banks. The law also created the Federal Deposit Insurance Corporation (FDIC), which insures customer deposits in banks.
The Glass-Steagall Act helped to reshape the banking sector for decades. However, after intense lobbying from the banking sector, the rules were repealed in 1999 by President Bill Clinton. As a result, banks started offering more services to customers in a bid to boost their returns.
The increased risk-taking led to the Global Financial Crisis in 2008, which caused trillions in losses. As a result, policymakers responded by creating the Dodd-Frank regulations, which included the Volcker Rule.
What is the Volcker Rule?
The Volcker Rule is a set of regulations that bar banks from engaging in several activities in a bid to protect customers. Precisely, they prevent banks from engaging in proprietary trading, investing in hedge funds, and private equity funds. The rules mirrored those in the Glass-Steagall Act.
The goal of this rule is to prevent banks from engaging in risky behavior using customer funds. Before the creation of this rule, banks were known for using customer funds to create risky financial assets like mortgage-backed securities (MBS) and Collateralized Debt Obligations (CDOs).
The rule had other provisions that barred banks from sponsoring a covered fund unless it abides by several requirements. Also, the sponsorship falls within an exception for non-US activities.
The Volcker Rule has some proponents, who believe that it helps to secure the banking sector. However, it also has its critics who believe that the rule puts banks in a difficult place when managing risks and capital. Also, banks have managed to circumvent some of these rules.
What is the Volcker Rule 2.0?
Wall Street banks don’t like regulations. Therefore, these companies spent millions of dollars lobbying Congress to simplify them. This opportunity came during the Trump administration, which was focused on reducing regulations.
As part of the Volcker Rule 2.0, the regulators tweaked the original rule to exclude several funds, including credit funds, venture capital funds, family wealth management, and customer facilitation funds. The 2.0 version of this regulation also changed the definition of trading account and trading desk.
What are the purposes of the Volcker Rule?
The rule was proposed in a bid to prevent depositors in American banks from being harmed by their activities. As part of these regulations, banks are prevented from participating in high-risk activities like trading and investing customer funds in risky assets.
These rules were crucial because of the importance of the banking sector to the economy. In most cases, when banks collapse, they can sink with the overall economy. After the 2008/9 financial crisis, the biggest Wall Street banks were bailed out in a $700 billion package that was signed by Obama.
It is worth noting that big American banks are still able to offer diverse services, including trading and investing. Giants like JP Morgan and Bank of America make money by both retail banking and investment banking. In their investment banking, these firms make money by underwriting IPOs, advising on mergers and acquisitions, and other activities.
While the Volcker Rule has been effective, the banking sector has not been immune to challenges. In 2023, some of the biggest regional banks like Signature, First Republic, and Silicon Valley Bank collapsed.
Volcker Rule and day trading
As part of the Volcker Rule, deposit-taking institutions, especially banks, are prevented from using their accounts for short-term day trading. In this, they are prohibited from short-term proprietary trading of securities, derivatives, and commodity futures.
The rule stems from the fact that many banks took substantial risks before the financial crisis. Many of them had huge trading floors, where they placed substantial trades and often made losses.
Precisely, policymakers criticized banks like Goldman Sachs for recommending their customers buy assets that they were actually shorting. Therefore, by preventing them from trading, the Volcker rule helped to reduce substantial risks in the market.
Volcker and proprietary trading
Proprietary trading, also known as prop trading, is also a key part of the Volcker rule. Prop trading, in this case, is defined as the practice where banks buy and sell financial assets using the bank’s own funds. These companies are prevented from trading key assets like derivatives and securities.
As mentioned, the goal of these restrictions is to prevent risks to banks themselves and the broader economy. As the recent bank failures have shown, their collapses can be highly expensive. For example, the collapse of companies like Signature and SVB led to billions of dollars in bailout funds.
Prop trading and market making under volcker rule
In the previous part, we have seen that the Volcker Rule barred banks from engaging in prop trading activities. The rules also included a thing about market making, which is a situation where a firm stands ready to buy and sell assets at a quoted price.
Today, market making is mostly done by companies like Virtu Finance and Citadel Securities, which control a huge part of the industry.
Under Volcker Rule, banks are also allowed to do market making to satisfy the reasonably expected near-term demands for clients, popularly known as RENTD.
As part of the RENTD policies, banks are required to come up with policies to ensure that their activities are driven by consumer demand instead of speculative activity.
Some of the other things the bank must do are to demonstrate that the activities are accepted by the Volcker Rule, it must have a customer or counterparty relationship, and must meet the customers short or long-term needs.
Criticisms of the Volcker rule
There have been numerous criticisms of the Volcker Rule. First, some experts believe that these rules, together with the broader Dodd-Frank, helped to create the too big to fail banks.
Today, the banking industry has become more concentrated than it was before the Global Financial Crisis. Companies like JP Morgan, BoFA, Citi, and Wells Fargo have become bigger than they were before the crisis.
Second, studies have found that the cost to customers rose gradually for some of the products and services. At the same time, the rules did not prevent banks from making risky investments and trades, which explains the collapse of SVB and Signature Bank.
The Volcker Rules also led to adverse liquidity effects in these companies’ bond trading desks. It also led to more use of non-bank dealers, who are exempt from the rule itself. These companies lack emergency liquidity support because they don’t have access to the Fed’s discount window.
External useful resources
- Hollowing Out the Volcker Rule – American Progress