Q&A: What is the Volcker Rule, and how does it work?
Government regulators have approved the “Volcker Rule,” which was created to prevent big banks from trading for their own benefit rather than on behalf of customers. Here are answers to questions about the new regulations.
The Washington Post
Government regulators have approved 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.
Q: What is the Volcker Rule?
A: 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.
Q: Wait, so the Dodd-Frank Act passed more than three years ago. Why is this happening now?
A: 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 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.
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 Volcker to go into effect as slowly, and with as many exemptions, as your lobbyists and lawyers can figure out.
Q: What’s a Volcker?
A: The rule is named for Paul 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. While Volcker 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.
Q: So this is to stop the kind of speculation that caused the financial crisis, right?
A: Nope! You can’t really trace any of the major financial failures (or near-failures averted by bailout) 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: 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.
Q: So why are these new rules 71 pages long? Seems like it should be simple enough to tell banks “no speculating.”
A: The problem is that the line between speculating and more legitimate banking activities like hedging can be exceptionally thin. Here are the two big areas.
Suppose you are a regulator and you see that a bank you oversee holds millions of dollars worth of options betting that the value of, say, the Brazilian real will fall relative to the dollar. “What is this?” you say. “You know you aren’t allowed to speculate on currencies under the Volcker Rule.”
The banker replies, “I’m not speculating on the Brazilian currency! I have this huge loan that I made to a Brazilian construction company. And they make all their money in reals. So all I’m doing is guarding myself against the risk the real falls, and I won’t get my loan repaid. This is reducing the risk that the bank faces, not increasing it!”
Q: So how does the draft rule deal with that tension?
A: The approach is to demand that banks specifically connect securities holdings to what specifically it is supposed to hedge. No vague stuff. In other words, the balance is: You can hedge, but you have to show us exactly what, why, and how — and you can count on us asking tough questions.
Q: What are other exceptions to the rule?
A: 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.
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 U.S. government and municipal debt with few restrictions.
Q: Is the Volcker Rule having an effect?
A: A number of banks that had gotten into the hedge fund and private equity businesses during the pre-crisis era have been closing or selling off those units.
Q: When does this all go into effect?
A: 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.