Government regulators have adopted the Volcker Rule, which was created to prevent big banks from trading for their own benefit rather than on behalf of customers. It also bars banks from making trades merely for profit and prohibits them from owning hedge funds and private equity funds.
What is the Volcker Rule?
It is part of the Dodd-Frank financial reform act that passed in 2010 that aims to prevent giant banks from engaging in speculative trading activity. The idea is that, while it is important for banks to support the economy by lending to consumers and businesses, when they get into the realm of making bets in exotic financial markets — known as proprietary trading — they aren’t really doing anything to support the economy. But trading for their own accounts does risk their own solvency in ways that could lead them to fail and necessitate a costly government bailout. In short, the theory is: You can speculate on financial markets. Or you can have a government safety net. But you can’t have both.
Wait, so the Dodd-Frank Act passed more than three years ago. Why is this happening now?
As regulators have done the actual work of turning the broad language of the Dodd-Frank law into detailed regulations that the banks must follow, they’ve found that it is easier to describe the idea of what counts as speculative activity than it is to codify it in a law. They’ve spent the last three years trying to do just that.
Adding to the complexity, five different regulators (with different areas of emphasis, priorities, and structures) have had to agree on the rules that enforce the Volcker Rule: The three major bank regulators (the Federal Reserve, Federal Deposit Insurance Corp., and Office of the Comptroller of the Currency) and two major market regulators (Securities and Exchange Commission and Commodity Futures Trading Commission). You try to get five regulators to agree on anything, whether language on what counts as trading activity or what to order for lunch. The treasury secretary, meanwhile, previously Timothy Geithner and now Jack Lew, has tried to push the process along though without a formal role in writing the rules.
Finally, all this has occurred against a backdrop of intense lobbying and legal challenges by the financial firms affected. It is only logical that if you are a bank that makes billions from trading, you will want the rule to go into effect as slowly, and with as many exemptions, as your lobbyists and lawyers can figure out.
What’s a Volcker?
The rule is named for Paul A. Volcker, chairman of the Federal Reserve during the 1980s and an elder statesman of the financial world. He was an early adviser of Barack Obama during his 2008 campaign for president, and while he often found himself squeezed out of decision making on financial and economic matters once Obama took office, one area where he prevailed was in persuading the president and his team to adopt a rule to try to stop speculation by banks.
So this is to stop the kind of speculation that caused the financial crisis, right?
Nope! You can’t really trace any of the major financial failures to proprietary trading by the giant banks, as banking industry representatives are quick to point out. As Benn Steil of the Council on Foreign Relations wrote, ‘‘A ‘Volcker rule’ — a ban on proprietary trading by commercial banks — would have done nothing to mitigate the worst financial crisis since the Great Depression.’’ The Financial Crisis Inquiry Commission did not identify speculative trading by banks as a factor in the crisis.
Volcker and his allies respond this way: Not so fast. Just because proprietary trading wasn’t the leading cause of the last crisis doesn’t mean losses on large trading positions didn’t contribute to the crisis. And trading could easily cause future problems for a too-big-to-fail institution. It’s a pattern that has replayed through history; the $6 billion trading losses by JPMorgan Chase in the recent ‘‘London Whale’’ episode is a prime example.
And there is a broader argument that when giant banks that carry an implicit public safety net (through things like FDIC deposit insurance and access to emergency Fed lending) do speculative trading, they are essentially shifting risks onto the taxpayer without any real benefit to the economy.
What are exceptions to the rule?
Market making is a big one. One business of major Wall Street firms is to help ensure that there is always a viable market for the securities their customers need. So suppose an industrial company wants to protect against the risk that oil prices will rise in the future, raising its costs. Banks will help them carry out the purchase of crude oil futures, and typically will stand ready to sell them if for whatever reasons nobody else is in the market looking to sell them.
Essentially, under the new regulations the Volcker Rule will let banks continue engaging in ‘‘market making,’’ but there are steps to keep them from using that to hide speculative activity. For example, trading desks would not be allowed to hold securities that exceed the demand from customers that could reasonably be expected.
Other exceptions to the rules include ‘‘underwriting’’ securities — when a company wants to sell bonds or shares of its stock, its banker will hold them temporarily while preparing to sell them on the broader market. And there are exceptions that allow banks to hold US government and municipal debt with few restrictions.
When does this all go into effect?
The bank regulators are giving firms quite a while to fully comply with the rules: Until July 21, 2015. So yeah, another year and a half. Apparently unwinding existing business lines that don’t comply with the rules is no overnight job.
So is it going to work? And at what cost?
What do you mean by work? The rule will certainly keep banks out of some areas that have proven risky in the past and exposed them to losses. Lew has said the rule would keep the London Whale trading loss from happening again, for example. The rule isn’t enough to prevent any future crisis, certainly. Banks have shown plenty of ability to get into trouble with strategies that have nothing to do with proprietary trading. For example, nothing about these rules would stop a bank from making crummy mortgage loans. But it is certainly plausible that this will choke off one route by which the biggest banks could come into danger of triggering another financial crisis.
The costs are similarly uncertain. If you’re a business looking to hedge this exposure or that, the curbs on market making activity could make it a little harder or more expensive, banking industry lobbyists have argued. And speculative activity could shift away from giant banks, which are intensively regulated, and into unregulated vehicles like hedge funds, creating potential new risks.
But what is clear is this: Three years after Dodd-Frank was enacted and nearly four years since Volcker stood with the president to propose limits on trading, we now know more about what this will mean in practice.