The Volcker Rule Was Misguided and Unnecessary

Report Markets and Finance

The Volcker Rule Was Misguided and Unnecessary

June 13, 2017 9 min read Download Report
Norbert Michel
Director, Center for Data Analysis
Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

Summary

The Financial CHOICE Act repeals the Volcker Rule. Advocates argue that the Volcker Rule is a vital piece of how Dodd–Frank improves the safety of financial markets. The Volcker Rule supposedly protects taxpayers by prohibiting banks from engaging in proprietary trading—that is, making risky investments solely for their own profit. Prior to the passing of Dodd–Frank, federal regulators already had—and used—the authority to regulate proprietary trading. In short, a much simpler version of the Volcker Rule already existed.

Key Takeaways

The Financial CHOICE Act repeals the Volcker Rule, which prohibits banks, with certain exceptions, from engaging in proprietary trading.

Federal regulators have had the authority to regulate proprietary trading ever since Congress passed the 1933 Banking Act.

Because a much simpler version of the Volcker Rule already existed, the rule is both misguided and unnecessary.

The U.S. House of Representatives has passed the Financial CHOICE Act, a major financial regulatory reform bill.[REF] One of the key reforms included in the bill is the repeal of section 619 of the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act. Section 619 required implementation of the Volcker Rule. Proponents continue to tout the Volcker Rule as a vital feature of Dodd–Frank that improves the safety of financial markets. However, a careful examination reveals that the Volcker Rule was both misguided and unnecessary.[REF]

The Volcker Rule

Section 619 of the Dodd–Frank Act required federal regulators to implement what is known as the Volcker Rule. This rule prohibits banks, with certain exceptions, from engaging in proprietary trading. The idea is to limit banks’ ability to make securities trades solely for their own account rather than for their customers. The rule also prohibits, with exceptions, banks from investing in certain “covered funds,” such as hedge funds and private equity funds.[REF]

Partly due to the difficulty in distinguishing between proprietary trading and providing trading opportunities for customers (market making), the final rule includes exemptions for certain activities. These activities include “market making, underwriting, hedging, trading in certain government obligations, and organizing and offering a hedge fund or private equity fund, among others.”[REF] Additionally, proprietary trading is still allowed in U.S. government, agency, state, and municipal bonds, as well as foreign sovereign debt instruments. There is evidence that the Volcker Rule has decreased banks’ proprietary trading activities, but this outcome is not necessarily a positive result.[REF]

A Faulty Concept of Risky Activity

Because financial risks are subjective, government-imposed rules that prevent people from taking risks they want to take end up distorting the pricing of risk throughout financial markets. Regulations such as the Volcker Rule produce negative outcomes because they rely on subjective distinctions between types of financial risk. Although it seems logical to stop federally insured banks from making risky bets, every commercial loan is a risky bet on whether the borrower will repay the loan.

Although some aspects of commercial lending may seem safer than short-term securities trading, commercial lending typically creates more liquidity risk than securities trading. While regularly traded securities in general have many buyers, individual commercial loans typically have no buyers.[REF] Thus, restricting a bank to one type of risky activity can actually increase its overall risk. At the same time, this restriction creates a second specialized entity for securities trading, resulting in two types of financial entities that cannot fully diversify their risk.

Separately, because banks must take risks to remain profitable, any regulation that prohibits some types of risky activity is likely to lead to an increase in other types of risky activity. Imposing an outright ban on proprietary trades, for instance, could cause some banks to increase the risk in their commercial loan books as they strived to maintain the same profitability. Indeed, some evidence shows that banks acted in precisely this manner before the Volcker Rule was even fully implemented.[REF]

A Simpler Version of Volcker Already Existed

It runs wholly counter to the conventional narrative surrounding the 2008 financial crisis, but federal regulators had the authority to regulate proprietary trading ever since Congress passed the 1933 Banking Act, otherwise known as the Glass–Steagall Act. Specifically, section 16 of Glass–Steagall, which Congress did not repeal, provided the necessary authority to regulate proprietary trading.[REF]

Section 16 prohibited:

  • Nationally chartered banks from securities dealing except for buying or selling securities “without recourse, solely upon the order, and for the account of, customers.”[REF]
  • Nationally chartered banks from purchasing investment securities for their own trading account except “under such limitations and restrictions as the Comptroller of the Currency may by regulation prescribe.”[REF]

The Comptroller did issue rules regulating “money market investments and securities purchased by the bank for its own account.”[REF] Several key passages from the rules, taken verbatim, are as follows:

  • “Investments, like loans, are extensions of credit involving risks that carry commensurate rewards. However, risks in the investment portfolio should be minimized to ensure that liquidity and marketability are maintained. Bank management must recognize that the investment account is primarily a secondary reserve for liquidity rather than a vehicle to generate speculative profits. Speculation in marginal securities to generate more favorable yields is an unsound banking practice.”[REF]
  • “National banks are governed in their security investments by the seventh paragraph of 12 USC 24 and by the investment securities regulation of the Comptroller of the Currency (12 CFR 1). The investment securities regulation defines investment securities; political subdivision; general obligation; and Type I, II, and III securities, and establishes limitations on the bank’s investment in those securities. The law, 12 USC 24, requires that for a security to qualify as an investment security, it be marketable and not predominantly speculative.”[REF]
  • “For its own account…[t]he purchase of Type II and III securities (see 12 CFR 1.3(d) and (e)) is limited to 10 percent of capital and surplus for each obligor when the purchase is based on adequate evidence of the maker’s ability to perform. That limitation is reduced to 5 percent of capital and surplus for all obligors in the aggregate where the purchase judgment is predicated on ‘reliable estimates.’”[REF]
  • “Shares of investment companies whose portfolios contain investments subject to the limits of 12 USC 24 or 84 may only be held in an amount not to exceed 10 percent of capital and surplus. That is, a bank may invest only an amount not to exceed 10 percent of its capital and surplus in each such investment company.”[REF]

Separate from whether such regulations are effective or appropriate, the fact remains that, prior to Dodd–Frank, federal regulators used their existing authority to regulate proprietary trading and to ensure commercial banks only conducted a limited amount of such activities.[REF]

Conclusion

The Financial CHOICE Act repeals the Volcker Rule. Advocates argue that the Volcker Rule is a vital piece of how Dodd–Frank improves the safety of financial markets. A careful examination, however, reveals that the Volcker Rule was both misguided and unnecessary.

The Volcker Rule supposedly protects taxpayers by prohibiting banks from engaging in proprietary trading—that is, making risky investments solely for their own profit. Although it seems logical to stop banks from making risky bets with federally insured deposits, banks make risky investments with federally insured deposits every time they make a loan—after all, there is always a chance a borrower will default. Prior to the passing of Dodd–Frank, federal regulators already had—and used—the authority to regulate proprietary trading. In short, a much simpler version of the Volcker Rule already existed.

Norbert J. Michel, PhD, is Senior Research Fellow in Financial Regulations and Monetary Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom, at The Heritage Foundation.

Authors

Norbert Michel
Norbert Michel

Director, Center for Data Analysis