PRIMER: the Volcker Rule

Author: John Crabb | Published: 10 Aug 2017
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What is the Volcker Rule and why does it exist?

Section 619 of the Dodd-Frank Act is generally referred to as the Volcker Rule. Although Dodd-Frank, which aims to repair the US financial system and end too big to fail, came into effect in 2010, shortly after the financial crisis, the Obama-era rule was only fully implemented on July 21 2015 following significant delays.

Named after its creator – former Federal Reserve chairman Paul Volcker, who led the US economic recovery following the financial crisis - the Volcker Rule is a US federal regulation that aims to prevent banks from making the kind of risky speculative investments using their own accounts that are widely believed to have contributed to the 2008 financial crisis.

The rule was approved by five implementing agencies before passing into law: the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission (SEC).

"The Rule aims to prevent banks from making the kind of risky speculative investments using their own accounts that are widely believed to have contributed to the 2008 financial crisis"

As laid out in the agencies’ joint Final Rule, the regulation:

“generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with a hedge fund or private equity fund (covered fund), subject to certain exemptions.”

It also provides that:

“a nonbank financial company designated by the Financial Stability Oversight Council (FSOC) for supervision by the Board (while not a banking entity under section 13 of the BHC Act) would be subject to additional capital requirements, quantitative limits, or other restrictions if the company engages in certain proprietary trading or covered fund activities.”

Why is it controversial?

Despite its good intentions of prohibiting risk trading and investment, and imposing safety and soundness on a market following a period of extreme difficulty, the Rule has turned out to be incredibly divisive. It is one thing to address problems head on, but it is another thing to define them - as the more than 950 page final document (complete with nearly 3,000 footnotes) would suggest.

The main opponents of the Rule come from the US banking sector, the hardest hit by the ban on proprietary trading, who argue that the rule is so complex that it is doing more harm than good by limiting banking activity. There are a number of other objections.

In a 2017 letter to shareholders, JP Morgan’s chairman and chief executive, Jamie Dimon, said that five regulators overseeing the rule is problematic. “This leads to slow rulemaking, excessive reporting and varied interpretations on what the actual rules are,” he said.

Volcker Rule matters: Volcker meets with President Obama shortly before announcing the rule in 2010

In a testimony to Congress on the Rule, Douglas Elliott at Washington DC-based think tank Brookings characterised why he believed the Volcker Rule is fundamentally flawed.

“It seems to me to be trying to eliminate excessive investment risk at our core financial institutions without measuring either the level of investment risk or the capacity of the institutions to handle the risk,” he said. “Instead, the rule focuses on the intent of the investment rather than its risk characteristics.”

Another line of argument which is often used against the Rule focuses on its core principal, suggesting that proprietary trading did not actually cause the financial crisis in 2008, and that it was never the best method of reducing financial risk.  

“The crisis was caused by good old fashioned real estate overlending, and it was derivative real estate securities that blew up the world,” said Richard Farley, partner at Kramer Levin Naftalis & Frankel.

But some are even more critical. “The Volcker Rule is a solution to a problem that didn’t exist,” said a senior lawyer at another leading US firm.

The final regulation contains a significant number of exclusions and exemptions from proprietary trading restrictions, which makes it very complex to clearly ascertain which activities fit where, and what activities don’t fit at all.

One of the most widely used - and indeed publicly commented on - of these is the market making exemption, which affects the functioning of equity and fixed income markets. Those who attack the rule say that for customers it is impossible to make a distinction between proprietary trading and market making.

In a statement on the subject, the SEC said that market making is critical to the function that broker-dealers perform in supplying liquidity and helping to raise capital, and that the regulators were tasked with upholding the general ban on proprietary trading while allowing banks to continue to supply essential liquidity to the securities and derivatives markets.

More recently however, there have been suggestions that there is a credible basis for the view that Volcker Rule has caused a reduction in market liquidity that could cause fragility of the markets.

“I think everyone agrees that banks should be able to engage in customer facing markets activities, and I think the market making provision can be revised to facilitate that, and avoid banks unnecessarily withdrawing from that critical market intermediary function,” said David Portilla, partner at Debevoise & Plimpton.

A further aspect of the Volcker Rule to be contested is its international reach – it applies not only to US banks but to foreign banks with affiliates in the country – which, as outlined by the Institute of International Bankers, is said to be overly broad and limits foreign investment to the US banking system. 

To outline every contestation to the Volcker Rule would be overwhelming, as there are many. The original reasons for its adoption remain the key arguments for its proponents:  that it is a wholly necessary response to a failure on systemic proportions that allowed banks to risk everything for profit at the expense of the taxpayer.

What does the current administration want to do with it?

The future of the Volcker is part of the wider debate on the current US regulatory framework – those in favour of the rule say it is a necessary economic safeguard, while those against it say that it is damaging growth. One of the campaign promises of President Trump was to deregulate wherever possible, and his January 3 executive order called for a two-for-one policy whereby each financial regulation that was enacted was made way for by disposing of two. Trump has often indicated that he wants to overhaul the Volcker Rule dramatically, a process that will likely put the power back into the hands of the banks.

"The Volcker Rule is a solution to a problem that didn’t exist"

This June, the US Treasury Department, spearheaded by secretary of the Treasury Steven Mnuchin,  released a 150-page report on how to realign the US financial system in a way that was consistent with Trump’s stance. The report extensively addressed the Volcker Rule, stating clearly that it ‘requires substantial amendment’ and recommended significant changes to be made – including changes to the statute, regulations and supervision.

“Its implementation has hindered market making functions necessary to ensure a healthy level of market liquidity,” reads the report. “Combined with high liquid asset buffers, and limited time to restore buffers during periods of stress, the Volcker Rule could result in pro-cyclical behaviour and reinforce market volatility during periods of stress.”

But can Volcker be improved?

No matter what side of the fence you sit on, with this much controversy, it is clear that the rule does need a second look. Even Mr. Volcker himself suggested that more clarity was needed in an exclusive 2015 IFLR interview.

“There are still questions about the Volcker Rule's international application and over clearing through New York City, as well as some technical questions and about defining hedging,” he said.

The Treasury report goes on to suggest several ways in which the Rule can be improved, which would, theoretically, ‘reduce the scope and complexity of the Volcker Rule and allow banks more easily to hedge the risks of their activities and conduct the market-making activities on which the liquidity of our markets depends.”

The report’s recommendations are to:

  • exempt smaller institutions or those financial institutions who do not pose a risk to financial stability;
  • exempt banks with $10 billion or less in assets  who do not engage in proprietary trading;
  • exempt banks over $10 billion in assets with few trading assets;
  • improve regulatory coordination between the five implementing agencies, to avoid fragmentation and confusion;
  • clarify and simplify the proprietary trading prohibition and exemptions, including the definition of proprietary trading and covered funds restrictions; 
  • provide increased flexibility for market-making;
  • reduce the burden of hedging business risks;
  • reduce the burdens of the Volcker Rule’s compliance regime; and
  • create an off-ramp for highly capitalised banks.

Where are we at now?

The Volcker Rule was clearly a very a complicated task that Congress gave to the five agencies, and they handled it as well as could be expected in the first place. Seven years after inception, and two years after implementation, the agencies have gathered a lot of data, and learned where it works and where it doesn't.

Last week, the OCC was the first to officially request comment on the Volcker Rule, a move that was widely accepted by the market, as well as other regulators, who agreed that it is time to take a second look.

In the August 1 notice, the OCC requested public assistance in ‘determining how the final rule should be revised to better accomplish the purposes of the statute’.

“The big takeaway is that there will be changes, they may happen over a decent time horizon but there will be changes,” said Portilla. “There will be an opportunity to provide comment and hopefully avoid the type of unintended consequences we had the first time around.” 

See also

Bankers' counsel poll: Volcker Rule compliance

How the Volcker Rule could have succeeded

Trump: prospects for Volcker

PRIMER: green bonds