The Volcker Rule: What Is It?
The Volcker Rule is a federal regulation restricting banks’ interactions with hedge funds and private equity firms, often known as covered funds. It typically forbids them from engaging in specific investment activities with their accounts.
Knowledge of the Volcker Rule
By prohibiting banks from undertaking specific kinds of speculative investments that fueled the 2007–2008 financial crisis, the Volcker Rule seeks to safeguard bank clients. It says that banks are not allowed to trade securities, derivatives, commodity futures, or options on any of these products on a short-term basis using their accounts.
To make it more transparent about what securities trading was and was not permitted by banks, the Office of the Comptroller of the Currency (OCC) in the United States decided to alter the Volcker Rule in August 2019.
Federal Deposit Insurance Corp. (FDIC) officials said on June 25, 2020, that the agency will relax the Volcker Rule’s requirements, making it easier for banks to make sizable investments in venture capital and related funds.
By prohibiting banks from undertaking specific kinds of speculative investments that fueled the 2007–2008 financial crisis, the Volcker Rule seeks to safeguard bank clients.
Furthermore, banks won’t need to reserve as much money for trades in derivatives between several divisions of the same company. That condition was included in the original rule to prevent banks from going bankrupt if speculative derivative bets went awry. Reducing those restrictions might allow the business to access billions in funding.
Paul Volcker, a former Federal Reserve (Fed) Chair and economist, passed away on December 8, 2019, at 92. The Volcker Rule remembers him.
Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 establishes guidelines for carrying out Section 13 of the Bank Holding Company Act of 1956. This part is known as the Volcker Rule.
The Volcker Rule prohibits banks and insured depository institutions from purchasing or holding ownership interests in hedge funds or private equity firms, subject to specific exceptions.
Put another way, by prohibiting banks from using their capital to undertake these investments to increase profits, the law seeks to deter banks from taking on excessive risk. The Volcker Rule is predicated on the idea that bank customers do not gain from these speculative trading operations.
Banks must comply fully with the rule by July 21, 2015. However, the Fed has since established processes to request an extension of time to achieve complete compliance for specific operations and investments. The rule went into effect on April 1, 2014.
On May 30, 2018, the Federal Reserve Board, chaired by Jerome “Jay” Powell, unanimously decided to advance a proposal to ease the Volcker Rule’s constraints and lower the expenses for banks that must abide by it.
“To replace overly complex and inefficient requirements with a more streamlined set of requirements” was the stated objective, according to Powell.
As it is, the rule permits banks to carry on their market-making, underwriting, hedging, trading, insurance company operations, hedge fund and private equity fund offerings, and agent, broker, or custodian roles. To make money, banks could keep providing these services to their clients. Banks are prohibited from engaging in these activities, though, if doing so would result in a severe conflict of interest, expose the organization to high-risk investments or trading techniques, or cause instability in the bank or the U.S. financial system.
Banks must comply with different reporting standards based on size to inform the government about their covered trading activity. More prestigious institutions must implement a procedure to guarantee adherence to the new rules, and their plans must undergo testing and review by outside experts. The criteria for compliance and reporting are less stringent for smaller organizations.
Further Background on the Volcker Rule
The rule’s inception may be traced back to 2009, when Volcker proposed a regulation to forbid banks from engaging in market speculation in reaction to the then-current financial crisis (following the accumulation of substantial losses by the country’s biggest banks from their proprietary trading divisions). In the end, Volcker aspired to restore the distinction that formerly existed between commercial and investment banking but was declared void by the 1999 partial repeal of the Glass-Steagall Act.
The Volcker Rule was included in Congress’s January 2010 proposal for a financial overhaul, despite not being included in then-President Barack Obama’s initial proposal.
Five federal agencies—the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the OCC, the FDIC, and the Board of Governors of the Federal Reserve—approved the Volcker Rule’s final regulations in December 2013.
Suppose a bank’s total consolidated assets are less than $10 billion, and its total trading assets and liabilities do not account for 5% or more of its total consolidated assets. In that case, it may be exempt from the Volcker Rule.
Disapproval of the Volcker Rule
Many people have attacked the Volcker Rule from a variety of perspectives. In 2017, the U.S. Chamber of Commerce asserted that the Volcker Rule’s costs outweighed its advantages and that no cost-benefit study had ever been conducted.
The same year, the International Monetary Fund’s (IMF) senior risk official stated that it is difficult to police rules designed to discourage speculative trades and that the Volcker Rule may inadvertently reduce bond market liquidity.
The Fed made similar claims in its Finance and Economics Discussion Series (FEDS), which stated that the Volcker Rule would decrease liquidity because banks would be doing less market-making.
The Volcker Rule and Market-Making in Times of Stress: A Discussion Series from the Federal Reserve System’s Divisions of Research and Statistics and Monetary Affairs Retrieved February 1, 2022.
In addition, a Reuters story from October 2017 stated that the European Union (EU) had abandoned a proposed regulation that many had called Europe’s version of the Volcker Rule, citing the lack of a likely agreement.
Several reports have indicated that the rule’s effect on big banks’ revenues was less severe than anticipated in the years following its introduction; however, its continued implementation may influence future operations.
The Volcker Rule’s future
President Donald Trump signed an executive order asking then-Treasury Secretary Steven Mnuchin to evaluate current banking sector laws in February 2017.
Treasury officials have published numerous studies suggesting modifications to Dodd-Frank since the executive order, including one that suggests granting banks more exemptions under the Volcker Rule.
One of the findings, which the Treasury released in June 2017, stated that it “supports in principle” the rule’s prohibitions on proprietary trading and makes significant recommendations for improvements to the Volcker Rule, but it does not accept its repeal. Notably, the paper suggests exempting banks with less than $10 billion in assets from the Volcker Rule. In addition to easing the regulation to make it easier for banks to manage their risks, the Treasury pointed out the regulatory compliance difficulties brought about by the rule. It recommended streamlining and improving the definitions of covered funds and proprietary trading.
According to a January 2018 Bloomberg story, the OCC has spearheaded attempts to amend the Volcker Rule in compliance with some of the Treasury’s suggestions since the June 2017 evaluation.
Although it would undoubtedly take months or years, it is still being determined when any suggested adjustments will go into effect. Bank regulators relaxed one of the Volcker Rule’s requirements in June 2020, enabling lenders to engage in venture capital funds and other assets.
Following President Joseph Biden’s election in 2020, the incoming administration indicated that it would like to undo the Trump administration’s regulatory cuts to the financial industry.
What was the Volcker Rule intended to achieve?
Paul Volcker, an economist and former chair of the Federal Reserve, first proposed the Volcker Rule in 2009 in response to the financial crisis that was still raging at the time and after the biggest banks in the nation had suffered sizable losses from their proprietary trading divisions. By prohibiting banks from undertaking specific kinds of speculative investments that exacerbated the crisis, the intention was to safeguard bank clients.
Essentially, it forbids banks from engaging in short-term proprietary trading of securities, derivatives, and commodity futures and options on any of these instruments using their accounts (client cash).
In the end, Volcker aspired to restore the distinction that formerly existed between commercial and investment banking but was declared void by the 1999 partial repeal of the Glass-Steagall Act.
What are the Volcker Rule’s primary detractors?
Many people have attacked the Volcker Rule from a variety of perspectives. In 2017, the U.S. Chamber of Commerce asserted that the Volcker Rule’s costs outweighed its advantages and that no cost-benefit study had ever been conducted.
According to the Fed’s Finance and Economics Discussion Series (FEDS), the Volcker Rule will result in less liquidity since banks will be doing less market-making.
Furthermore, economists at the International Monetary Fund (IMF) have contended that it is difficult to police laws designed to discourage speculative wagering.
The Glass-Steagall Act: What was it?
As part of the 1933 Banking Act, the United States Congress passed the Glass-Steagall Act in response to nearly 5,000 bank failures during the Great Depression. It was sponsored by Rep. Henry Steagall, the House Banking and Currency Committee chair, and Sen. Carter Glass, a former Treasury secretary, who forbade commercial banks from engaging in investment banking activities and vice versa.
The justification for this was the conflict of interest that developed when banks used their assets—which were their account holders’ assets—to invest in securities. In other words, the law’s supporters contended that banks had a fiduciary duty to safeguard these assets and refrain from speculative behavior.
The Final Word
The Volcker Rule prevents banks from engaging in high-risk, speculative trading activities, including proprietary trading, participating in hedge funds, or supporting private equity funds. It enables banks to provide crucial financial services focused on their clients’ needs, like asset management, market making, and underwriting.
The Federal Reserve Board, the CFTC, the FDIC, the OCC, and the SEC are the five federal financial regulatory agencies that produced the regulations. They are all mentioned above.
Conclusion
- Banks cannot use their accounts for short-term proprietary trading of securities, derivatives, or commodity futures and options on any instruments due to the Volcker Rule.
- Federal Deposit Insurance Corp. (FDIC) officials said on June 25, 2020, that the agency will relax the Volcker Rule’s requirements, making it easier for banks to make sizable investments in venture capital and related funds.
- The Volcker Rule’s primary detractors indicate that it will decrease liquidity since banks will do less market-making.
