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Volcker Rule

The Volcker Rule and Banking Reforms after the Crisis

The Volcker Rule restricts banks from engaging in proprietary trading and holding, sponsoring, or having a specific connection with private equity funds or hedge funds. 

The subprime mortgage crisis of 2007-2008 profoundly influenced the US and the world. It triggered various adverse consequences, including a housing market full of foreclosures, reduced real estate values, crippled banks, the TARP bailout, rising unemployment, public outcry, and a depressed economy.

On top of the initial devastating impact, it took years of struggle and reforms to stabilize the financial industry. 

One of the most important ones was the so-called Volcker rule. 

This article will explore the origin of the Volcker rule, its provisions, impact, and the controversies surrounding it.

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Understanding the Volcker Rule

According to estimates by the International Monetary Fund, the total global losses from the subprime crisis were $4 trillion.

To ensure this would never happen again, the Dodd–Frank Wall Street Reform and Consumer Protection Act was drafted and passed in July 2010 by the Obama administration. 

Here is the Full Title of the Act:

“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.”

It was named after the former Federal Reserve chairman, Paul Volcker. He proposed the rule to restrict the speculative trading activities of US banks, which was found to be hurting consumers. 

Enacting the Volcker Rule

To assist in recovering from the recession, President Obama formed the President’s Economic Recovery Advisory Board. This was a panel of experts with Paul Volcker as its chair. 

Volcker was a former Chairman of the Federal Reserve System under Carter and Reagan. 

He will remain in history as the one who made sure that banks could no longer speculate with their clients’ money.

Volcker saw that allowing banks to do so had been a notable factor in the crisis. 

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 its application, 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, the final version of the Volcker rule was somewhat softer. Banks were still allowed to invest in private equity and hedge funds but with up to 3% of their tier 1 capital. 

They also had permission to invest in treasuries. Any other proprietary trading was banned. This made the US banking system less prone to destabilization.  

What Were the Criticisms of the Volcker Rule?

Some of the criticisms of the Volcker Rule include: 

Reduced Liquidity 

One of the criticisms of the Volcker Rule is that it has the tendency to reduce liquidity due to a decrease in the market-making activities of banks. 

Complex Regulation

Due to the strict requirements for data, aggregation, collection, and reporting, the Volcker rule was viewed as being complex and challenging for banks. 

Lack of Practicality

The Volcker Rule was also criticized for its broad requirements, which might consequently lead to errors in the development and enforcement of a compliance program in line with the rule.  

How Does the Volcker Rule Reduce the Probability of Another Financial Crisis?

The primary aim of the Volcker Rule is to safeguard bank customers by prohibiting banks from making certain speculative investments that played a role in the financial crisis in 2007-2008. 

And with this rule, banks do not need to reserve a significant amount of cash for derivative trades among various units of the same institution. Alternatively, banks would always have a substantial section of their capital that won’t go towards speculative investments, ensuring they will maintain liquid enough to avoid potential stress.

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Takeaway: The Volcker Rule as a Way to Curb Risky Banking Practices and Protect Consumers

The Volcker Rule was a response to the 2007-2008 global financial crisis. The rule sought to protect the financial system from vulnerabilities by restricting short-term proprietary trading and connections between banks and private equity funds or hedge funds. 

While the rule faced criticisms for being too complex and a liquidity barrier, its implementation was a significant step toward promoting accountability, transparency, and consumer protection.

Thanks to it, the US banking system is now better equipped to prevent another crisis and protect consumers’ funds.