You’ve probably heard the term “Volcker Rule” thrown around a lot, especially as five separate financial regulators vote on whether to approve the final rule Tuesday. Here’s everything you need to know about about this central piece of the 2010 Dodd-Frank financial reform bill.
Who is the Volcker behind the Volcker Rule?
The rule was named for Paul Volcker, the chair of the Federal Reserve from 1979-1987.
What does the rule do?
The original intent of the rule was to ban banks who accept federally insured deposits (like your savings account) from making speculative bets with that money. Banks should be able to make home loans, for instance, but speculating on stock prices would be banned. As Volcker himself wrote last year:
“The basic public policy set out by the Dodd-Frank legislation is clear: the continuing explicit and implicit support by the Federal government of commercial banking organizations can be justified only to the extent those institutions provide essential financial services.”
That seems pretty straight forward. Why did it take so much time to implement the rule?
Because banks make a lot of money from activities that would be banned under this rule, and because a lot of legitimate activity might have been banned by a rule as simple as the one Volcker described, the financial industry fought its implementation tooth and nail. Many banks, for instance, make money simply by buying and selling securities for their customers. This business, called market making, involves keeping an inventory of financial instruments on your books and adjusting that inventory to meet demand. Another legitimate activity banks undertake is buying and selling derivatives in order to hedge risks associated with “providing essential financial services.” A mortgage-lending bank, for instance, will want to buy certain derivates designed to hedge against rising or falling interest rates. For the past couple years, regulators have been working together to carve out exceptions to the rule that would balance the spirit of the rule with the need for banks to engage in legitimate types of trading.
Would the rule have prevented the financial crisis?
The short answer is no. Over simplified accounts in the media have pointed to the commingling of speculative investment banking activity and traditional commercial banking as the reason why Wall Street blew up in 2008. While it is true that laws popularly known as the Glass-Steagall Act prevented this sort of thing for many years following the Great Depression, Glass-Steagall’s slow erosion by regulatory agencies and final repeal in the 1990s isn’t the reason for the subprime mortgage meltdown or the financial crisis. The fact of the matter is that some of the biggest villains of the financial crisis were either traditional savings and loans like Washington Mutual, or like Bear Stearns, were pure investment banks which didn’t rely on federally insured deposits. So even if the Volcker Rule had been in place, there’s reason to believe that these institutions could have still failed and triggered a crisis.
So why are reform advocates so insistent this rule be put in place?
Just because it wasn’t the super banks like JPMorgan, which straddle the worlds of commercial and investment banking, that triggered the crisis it doesn’t mean their business models didn’t contribute to financial instability. As FDIC Vice Chairman Thomas Hoenig explained earlier this year, banks like Citigroup and JPMorgan’s ability to draw from federally insured deposits encouraged pure investment banks like Bear Stears to fund themselves with risky short-term debt. The Volcker Rule would help remove the competitive pressure for banks to take on these kinds of risks.
Others have pointed out that regulations like the Volker Rule simply encourage banking institutions to be smaller and more focused on specific services. While this might make the banking industry a little less efficient, it does help eliminate the “too-big” part of “too-big-too-fail.” A more fragmented financial services industry is less systemically risky, making it easier for the feds to wind down troubled banks without resorting to bailouts.