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The Volcker Rule

The subprime mortgage crisis and related recession of 2007-2008 had a profound influence on America and the world. On top of the initial devastating impact, it took years of struggle and reforms to clean up the mess. Some of the major consequences of this crisis were a housing market full of foreclosures, reduced values of real estate, crippled banks, the TARP bailout, increase in unemployment, public outcry and a depressed economy.

The severity of these issues caused legislators to implement changes to much of the financial system in the aftermath. Estimates made by the International Monetary Fund put the total global losses from the subprime crisis at $4 trillion.

To ensure that this would never happen again, the Dodd-Frank Act Wall Street Reform and Consumer Protection Act was drafted and passed in July 2010. The long name for this act is An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

To assist in recovering from the recession, President Obama formed the President’s Economic Recovery Advisory Board. This was a panel of experts chaired by Paul Volcker, former Chairman of the Fed under Carter and Reagan. Volcker’s big contribution was the Volcker rule, stating that banks could no longer engage in speculation with their client’s money. Volcker saw that allowing banks to do so had been a big factor in the crisis, and that it was tantamount to proprietary trading.

Such sweeping change was of course resisted at many turns. Banks did not want these rules potentially stifling their profits. Some legislators sought to weaken aspects of it, often citing the need to save the good aspects of these banks engaging in proprietary trading. After seeing the first bill drafted, Volcker himself said: “I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

In the end, a somewhat softer version of the Volcker rule was implemented. Banks can still invest in private equity funds and hedge funds, with up to 3% of their tier 1 capital. They are also allowed to invest in treasuries. Other proprietary trading is banned, making the banking system in the US less likely to get out of control as it had before. Now when you venture out into the markets, you can rest assured that the big banks have somewhat less of a role in driving them.

See in: Informative
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