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Paul Volcker, the 12th Chair of the Federal Reserve, whom the Volcker Rule is named after
Source: Wikimedia Commons
What is the Volcker Rule?
The Volcker Rule (§ 619 of the Dodd–Frank Wall Street Reform and Consumer Protection Act (12 U.S.C. § 1851) outlaws ‘proprietary trading.’ Proprietary trading refers to when banks trade securities, derivatives, commodity futures, and options for their own account. Economist and then-Federal Reserve Chairman Paul Volcker was the first to propose such a rule, which would prevent U.S. banks from making certain kinds of speculative investments that do not benefit their customers.
The rule went into effect on April 1, 2014 and commercial banks generally had to demonstrate their full compliance by July 21, 2015. Some banks, however, requested a five-year grace period in order to exit illiquid investments. After years of off-and-on debate, the Federal Deposit Insurance Commission (FDIC) opted to ease restrictions of the Volcker Rule in 2020. This decision enabled commercial banks to more easily make large investments into venture capital and other funds.
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What the Volcker Rule Outlaws and Allows
As mentioned earlier, the Volcker Rule essentially prevents high-risk trading activities, conflicts of interest, and instability in financial markets. Larger institutions must also establish a program to ensure they comply with the regulations, and their measures must remain available to independent testing and analysis. Smaller institutions have less compliance and reporting requirements due to their much lower risk of catastrophic failure.
But let’s take a deeper look to see exactly what the rule outlaws and allows.
What the rule outlaws
1. Proprietary trading
The initial form of the Volcker Rule completely cracked down on credit default swaps (CDSs) and credit default obligations (CDOs), two financial instruments that heavily contributed to the 2008 financial crisis. In general, the rule prohibits banks from using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures, as well as options on any of these instruments.
The rule aims to deter banks from assuming excessive risk. Using depositor funds to make speculative investments can have disastrous consequences. Furthermore, these trading activities often do not benefit the banks’ customers.
2. Owning and investing in hedge and private equity funds
The Volcker Rule also prohibits banks, or insured depository institutions, from gaining or holding ownership stakes in hedge funds or private equity funds (subject to certain exemptions).
What the rule allows
The Volcker Rule allows trading in two circumstances:
1. Government Bonds
The rule attempts to prevent banks from making high risk investments. That means, banks are free to buy and sell low-risk securities—in particular, U.S. government bonds (e.g. Treasury bills). The government backs their bonds, so little risk of failure.
2. Trading required for business
Commercial banks can trade when it’s necessary to run their business (market-making, underwriting, hedging, and trading if it is to limit their own risk). For instance, they can trade currency to offset their foreign currency holdings.
Banks can also act as agent, broker, or custodian for their customers. They can trade on behalf of their clients, as long as they first receive approval. The banks themselves cannot engage in the activities directly.
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Revisions to the Volcker Rule
But the revised version of the rule, which went into effect October 1, 2020, loosened regulations somewhat. According to the SEC, the revisions primarily address “…the Volcker rule’s prohibition on banking entities investing in or sponsoring hedge funds or private equity funds—known as covered funds.”
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- Streamlining the covered funds portion of rule;
- Addressing the extraterritorial treatment of certain foreign funds; and
- Permitting banking entities to offer financial services and engage in other activities that do not raise concerns that the Volcker rule was intended to address.
”
The other major modification lowers the amount of cash banks need to set aside for derivatives trades between different units within the institution. Regulators included the cash requirement in order to ensure banks would not go under if their speculative derivative investments failed. Reducing the required amount of cash reverses could reportedly free up billions of dollars in capital for the finance industry.
Why Establish the Volcker Rule?
During the Great Depression, Congress instituted the Glass-Steagall Act of 1933. The legislation separated investment banking from commercial banking. Nevertheless, banking executives and lobbyists argued that the Glass-Steagall Act prevented banks from being internationally competitive.
In the late 90s, the legislation was not repealed but ‘neutered’ by the Gramm-Leach-Bliley Act. Banks had regained the ability to engage in previously prohibited commercial activities, including but not limited to insurance and investment banking. In other words, the proverbial floodgates had been opened. Banks could now use the mountains of deposited funds without limit.
Banks started opening up investment banking branches, gaining an arguably undue competitive advantage over local banks and credit unions. These multinational financial institutions could now provide any banking service a customer might want. They kept growing and growing, acquiring local establishments, until they became ‘too big to fail.’
Too big to fail essentially means that the failure of a company would have disastrous effects on the economy. If such a company does fail, the Federal Reserve often steps in as a lender of last resort in order to bail out the company. The catch is, the central bank uses taxpayer dollars to fund the rescue job.
The TARP (Troubled Asset Relief Program), the recovery effort after the subprime mortgage crisis, was projected to cost around $700 billion. The safety net of the system creates a moral hazard. Banks had everything to gain and little to lose, as taxpayers would have to cover the costs of failure without having any choice in the matter.
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The institution of the Volcker Rule and the subsequent revision have divided the public. Some argue that the rewrite has opened up opportunities for banks to trade dangerously. Banks have reportedly taken advantage of the loosened regulations already.
So, what do you think? Are the revisions to the Volcker Rule a positive or negative change? Does trading with depositor funds generate unnecessary risk that ultimately harms the public?
Yes or no, we at the Zero Theft Movement are dedicated to finding and eliminating the rigged parts of the U.S. economy so that American businesses and citizens can flourish. Our community works to calculate the most accurate estimate for the monetary costs of corruption in the United States.
We achieve this collectively through our independent voting platform. The public investigates potential problem areas, and everyone votes on whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Only through hard evidence can we prove where the rigged parts of the economy exist and force Congress to hold all the bad actors accountable.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.