Financial Reform: Overview of the Volcker Rule
July 9, 2018
Financial Reform: Overview of the Volcker Rule
Background
financial sector, which proved politically unpopular. These
Legislators and regulators have long grappled with whether
interventions raised concern about taxpayers’ exposure to
restricting the types of activities banks can engage in, or
financial crises. The fact that banks were protected from
reforming banks’ structures, might reduce the risk of large
potential losses by taxpayer-backed deposit insurance and
bank failures and the risk of systemic financial instability,
other federal assistance, such as short-term lending by the
such as that seen in the 2008 financial crisis. The Volcker
central bank, further aggravated concerns. The Volcker
Rule is an example of a means of addressing this issue.
Rule’s prohibition of proprietary trading attempts to prevent
bank holding companies whose depository banks have
The statutory basis of the Volcker Rule is Section 619 of
access to such government safety nets from speculating in
the Dodd-Frank Act, enacted in 2010 following the crisis. It
financial markets.
was conceived of by Paul Volcker, a former Federal
Reserve (Fed) chair, and implemented as “the Volcker
Issues in Volcker Rule Implementation
Rule” in a 2013 joint final rule by five financial regulators:
The Volcker Rule exempts certain securities, such as
the Fed, Federal Deposit Insurance Corporation (FDIC),
Treasuries, from the ban on proprietary trading. It also
Office of the Comptroller of the Currency (OCC),
exempts certain activities such as hedging and market
Securities and Exchange Commission (SEC), and
marking. A fundamental challenge in implementing the
Commodity Futures Trading Commission (CFTC).
Volcker Rule has been devising a clear way to distinguish
The Volcker Rule generally prohibits a depository bank (or
between trading by banks for speculative purposes and
company that owns one) from engaging in proprietary
other allowable purposes. From the outset, regulators and
trading or investing in (or sponsoring) a hedge fund or
academics acknowledged that it is difficult to discern
private equity fund. The rule has been subject to debate and
whether a financial trade is aimed at profiting from market
was recently amended through legislative action.
movements or hedging existing assets against market
Regulators have also proposed further changes to the rule.
movements. Market-making entails buying and selling
instruments, such as stocks or bonds, for the purpose of
Prior to the Dodd-Frank Act, no statutory definition of
fostering a liquid market in them, often for the benefit of a
proprietary trading existed, but the concept was generally
client, such as a company issuing shares. It can be hard to
understood to mean trading by an entity for its own profit
distinguish whether a firm is holding such securities in
and loss, rather than on behalf of a client for commission-
order to foster a liquid market or to profit from them.
or fee-based income. Section 619 defined the term, in part,
as “engaging as a principal for the trading account of the
To implement Section 619 of the Dodd-Frank Act,
banking entity or nonbank financial company…in any
regulators were challenged with creating standards to
transaction to purchase or sell, or otherwise acquire or
distinguish between these activities. This inherent challenge
dispose of” financial instruments, such as securities and
may have contributed to the final rule’s length and
derivatives.
accusations that it is overly complex and cumbersome to
follow and for bank supervisors to use. The Volcker Rule
A well-known prior example of a restriction on banks is the
has not only faced criticisms from opponents that it is too
Glass-Steagall Act, passed in 1933 during the Great
strict, lengthy, and burdensome, but also from proponents
Depression. Glass-Steagall generally prohibited certain
of financial reform and consumer advocates that it does not
deposit-taking banks from engaging in various securities
go far enough to prevent banks from proprietary trading.
markets activities associated with investment banks, such as
Some questioned why the 2013 rule presumed short-term
speculative investment in equity securities. Glass-Steagall
trades of less than 60 days to be proprietary unless
also prohibited banks from affiliating with securities firms.
otherwise proven, whereas longer-term trades were not
Over time, regulators became more permissive in their
subject to such a presumption.
interpretations of Glass-Steagall, allowing banks to
participate in more securities market activities, directly or
In an April 2017 speech, former Fed Governor Daniel
through affiliations. In 1999, the Gramm-Leach-Bliley Act
Tarullo, who helped implement the rule, flagged several
repealed two provisions of Glass-Steagall, which further
problems with it in practice. He noted that, although the
expanded permissible activities for certain banks and
purpose is worthy, the involvement of five different
permitted banks to affiliate with securities firms.
agencies made it complex to supervise and follow. He also
noted that the ongoing need for data-driven, contextual
The 2008 financial crisis rekindled the debate over what
guidance from the different regulators took up excessive
activities banks should be allowed to engage in. In the run-
regulatory and bank supervisors’ time and led to increased
up to the crisis, banks took on excessive risks, including
compliance costs for banks. He stated that the rule might
through proprietary trading in complex derivatives,
contribute to reduced market-making liquidity in some
mortgage-backed securities, and other financial
financial instruments and is unnecessarily costly for small-
instruments. Excessive risks led to losses that precipitated
and medium-sized banks with few trading activities.
substantial federal government financial assistance to the
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Financial Reform: Overview of the Volcker Rule
Legislative Changes
into this category. Firms with “limited trading
On May 24, 2018, President Trump signed into law P.L.
activity”―those with less than $1 billion of trading assets
115-174, which made a variety of changes to financial
and liabilities―would be presumed compliant. The Fed
regulation and to the Volcker Rule. First, the new law
estimated that the 40 banking organizations with significant
exempted any bank holding company with less than $10
or moderate trading activities account for 98% of total U.S.
billion in consolidated assets from having to comply with
trading activity by banking entities.
the Volcker Rule if the firm’s total trading assets or
In addition, the proposal modifies what constitutes
liabilities also do not exceed 5% of total consolidated
“proprietary trading” by eliminating the “rebuttable
assets.
presumption” in the Volcker Rule that trades held for less
Second, the law relaxes somewhat the prohibition on bank
than 60 days be presumed part of a proprietary trading
entities “sponsoring” hedge funds or private equity funds by
account unless the bank shows the intent of the trade was
sharing the bank’s name, or variant of it, with the fund – a
not for short-term trading gains. Banks complained this
practice usually used for marketing or promotional
requirement was too ambiguous and time-consuming. The
purposes. The ban’s initial logic was to prevent banks from
proposal eliminates this rebuttable presumption for short-
creating the impression, or the reality, that they would
term trades.
“backstop” such funds in bad times, which could potentially
create bank losses, and ultimately, the FDIC and taxpayer
Analysis of Changes
losses, if such losses proved severe. Banking associations,
Although the original Volcker Rule included tailoring for
however, argued that this restriction hindered banks’ role in
small banks, a broader exemption for smaller banks such as
capital formation and put them at a competitive
in the law and in the agencies’ proposal had been
disadvantage relative to nonbanks when it came to
anticipated for some time. Some observers were critical of
sponsoring such investment funds. The question of whether
asset-size thresholds as a regulatory standard for the
this disadvantage was intentional and desired, or unfair and
Volcker Rule, arguing it should be tailored based on the
undesirable, depends on one’s viewpoint. The new law
riskiness of the business model instead.
permits banks to share their names with such funds under
Neither the new law nor the agencies’ proposal makes
several circumstances. Regulators announced they will
substantial changes to the restriction on banking entities
incorporate these legislative changes into a future
investing in private equity or hedge funds, despite the
rulemaking.
modification of the naming prohibition on such funds. The
Agencies’ Proposal for Reform
proposal potentially relaxes certain requirements for banks’
ownership interests in covered funds when they relate to the
On May 30, 2018, the Fed released a new proposed rule
banks’ market making or underwriting activities.
that would revise the Volcker Rule. The proposal does not
address how to implement P.L. 115-174, which is to occur
Changes to the Volcker Rule in the agencies’ proposal and
in a separate rulemaking. The Fed stated in its Board memo
in P.L. 115-174 garnered significant, and divergent,
that “staff has identified opportunities, consistent with the
attention in the press and in Congress. Some Members of
statute…to incorporate additional tailoring…based on the
Congress, including the ranking members on the Senate
activities and risks of banking entities and to provide
Banking and House Financial Services Committees, argued
greater clarity about the activities that are prohibited and
that these changes would make it easier for banks to engage
permitted.” The Fed said the proposal would make it easier
in speculative trading, amplifying risks at these banks. In
for bank supervisors to assess compliance with the Volcker
contrast, proponents of these changes, including the Senate
Rule. The FDIC, OCC, SEC and CFTC, which had jointly
Banking Committee and House Financial Services chairs,
with the Fed issued the original Volcker Rule in 2013, each
said they would streamline regulation and improve clarity
voted to support the proposal, with dissents at the SEC and
and efficiency.
CFTC.
Outside of Congress, assessments of the modifications also
A key change is that the new proposal categorizes firms
diverged. The financial industry welcomed the changes,
based on their trading activities’ size and envisions that
saying it would reduce compliance burdens and increase
only those with the largest trading books will be subject to
regularity clarity. However, certain regulatory leaders
the most scrutiny. The Fed said this approach would more
opposed the changes. Two SEC commissioners and one
accurately tailor the regulation to the trading risk profile of
CFTC commissioner voted against the proposal. In dissents,
a firm rather than to its size by total assets. Firms that have
they stated that expanding what qualified as risk-mitigating
worldwide trading assets and liabilities―including those of
hedging (as opposed to proprietary trading) could
their affiliates―which exceed $10 billion when added over
potentially enable evasion of the rule. They voiced concern
the four previous quarters are considered “significant”
that relaxing the proprietary trading prohibition without
trading exposures. The Fed estimated this would cover 18
finalizing rules restricting compensation for excessive risk
banking organizations.
taking at banks would likely encourage such risk-taking.
Firms with more than $1 billion but less than $10 billion in
Rena S. Miller, Specialist in Financial Economics
trading assets are to be deemed to have “moderate” trading
activities and are to face significantly reduced compliance
IF10923
requirements. An additional 22 banking organizations fall
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Financial Reform: Overview of the Volcker Rule
Disclaimer
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https://crsreports.congress.gov | IF10923 · VERSION 2 · NEW