What Is the Volcker Rule?

What Is the Volcker Rule?

Let me explain the Volcker Rule directly: it's a federal regulation that stops banks from engaging in certain investment activities using their own accounts, and it also restricts their interactions with hedge funds and private equity funds. This rule forms part of the broader Dodd-Frank Act reforms from 2010.

Key Takeaways

You need to know that the Volcker Rule specifically prohibits banks from using their own accounts for short-term proprietary trading in securities, derivatives, commodity futures, and related options. In June 2020, the FDIC announced changes that eased restrictions, letting banks make larger investments in venture capital and similar funds. Critics point out that it reduces liquidity by limiting banks' market-making roles.

Understanding the Volcker Rule

The core aim of the Volcker Rule is to safeguard bank customers by barring banks from speculative investments that played a role in the 2007-2008 financial crisis. In essence, it prevents banks from using their own funds for short-term proprietary trading in securities, derivatives, commodity futures, and options on these.

Back in August 2019, the OCC voted to amend the rule to clarify allowed and disallowed securities trading. Then, on June 25, 2020, the FDIC loosened restrictions further, making it easier for banks to invest heavily in venture capital and similar funds.

Importantly, banks no longer need to reserve as much cash for derivatives trades between their own units—a measure originally designed to prevent wipeouts from bad speculative bets. The rule is named after Paul Volcker, the economist and former Fed chairman from 1979 to 1987, who passed away in 2019 at 92.

This rule is section 619 of the Dodd-Frank Act, implementing section 13 of the Bank Holding Company Act of 1956. It also prohibits banks from owning or retaining interests in hedge funds or private equity funds, with some exemptions, to discourage excessive risk with their own money.

Streamlining the Volcker Rule

The rule took effect on April 1, 2014, with full compliance required by July 21, 2015, though the Fed allows extensions for certain activities. In May 2018, under Chair Jerome Powell, the Fed unanimously proposed easing restrictions to cut compliance costs.

Powell stated the goal was to replace complex requirements with streamlined ones. Banks can still handle market making, underwriting, hedging, trading government securities, insurance activities, offering hedge and private equity funds, and acting as agents, brokers, or custodians.

They can provide these services to customers for profit, but not if it creates material conflicts, exposes them to high-risk assets, or threatens bank or U.S. financial stability. Based on size, banks face different reporting levels to disclose trading to the government; larger ones need compliance programs with independent testing, while smaller ones have lighter requirements.

Enacting the Volcker Rule

The rule's roots go back to 2009, when Volcker proposed it amid the financial crisis, after big banks suffered losses from proprietary trading. It aimed to stop banks from market speculation and restore the commercial-investment banking divide, undone by the 1999 partial repeal of Glass-Steagall.

Though not in Obama's initial overhaul, it was endorsed by him and added by Congress in January 2010. In December 2013, five agencies—the Fed, FDIC, OCC, CFTC, and SEC—approved the final regulations.

Note that banks with under $10 billion in assets and trading assets/liabilities below 5% of total assets may be exempt.

Criticism of the Volcker Rule

Critics from various sides have targeted the rule. The U.S. Chamber of Commerce in 2017 said no cost-benefit analysis was done and costs exceed benefits. The IMF's top risk official noted enforcement difficulties and potential unintended bond market liquidity drops.

The Fed's FEDS series argued it reduces liquidity via curtailed market-making. However, reports show big banks' revenues weren't hit as hard as expected post-enactment.

Recent Developments

In February 2017, Trump ordered a review of regulations, leading Treasury reports proposing Dodd-Frank changes, including Volcker Rule exemptions for banks under $10 billion in assets. Treasury supported the rule's principles but suggested simplifying definitions and easing hedging rules.

In June 2020, regulators allowed banks to invest in venture capital. Biden's administration aimed to reverse Trump-era weakenings but made no major Volcker changes. With Trump's return, banks expect broader deregulation.

What Was the Goal of the Volcker Rule?

The goal was to stop banks from high-risk investing that caused the 2008-2009 collapse. It bars using customer deposits for proprietary trading in securities, derivatives, commodities, and options, aiming to revive the Glass-Steagall divide between commercial and investment banking.

What Are the Main Criticisms of the Volcker Rule?

Key criticisms include the Chamber's view that costs outweigh benefits, FEDS' point on reduced liquidity from limited market-making, and Treasury's support for retention but with easing for compliance during Trump's first term.

What Was the Glass-Steagall Act?

The Glass-Steagall Act, part of the 1933 Banking Act, responded to Great Depression bank failures by separating commercial and investment banking. Sponsored by Sen. Carter Glass and Rep. Henry Steagall, it prevented banks from using depositors' money for speculative securities investments, citing fiduciary duties.

The Bottom Line

In summary, the Volcker Rule restricts banks' high-risk speculative trading, like proprietary activities or sponsoring hedge/private equity funds, while preserving customer services such as underwriting and market making. Five agencies—the Fed, CFTC, FDIC, OCC, and SEC—developed these regulations.