Killing the Volcker Rule

Last week, Federal Reserve Governor Jerome Powell made news by suggesting that Congress rewrite the Volcker Rule. Governor Powell noted that: “What the current law and rule do is effectively force you to look into the mind and heart of every trader on every trade to see what the intent is.” Powell’s comments come on the heels of recent research, including research by Fed economists, demonstrating that the Volcker Rule has thus far not been effective in accomplishing its intended goals, and may even harm market functioning. All this has provided longtime critics of the Volcker Rule with an “I told you so” moment, and given them hope that the incoming Trump administration, with its deregulatory slant, will kill the Volcker Rule once and for all. Regardless of one’s politics, it is important to objectively evaluate the Volcker Rule in order to understand the rule’s impact on financial institutions, regulatory agencies, and financial markets. A clear-eyed assessment will reveal that the Volcker Rule’s costs exceed its benefits, and that eliminating the rule would be prudent policy.

Volcker Rule History

The Volcker Rule was included as part of 2010’s Dodd-Frank Act.[1] The rule was intended to prohibit banking entities from engaging in two types of activities:

• Proprietary trading; and
• Acquiring or retaining a significant ownership interest in, or sponsoring, a covered fund (e.g. a hedge fund or private equity fund).

The rule was controversial from its inception, and opposition from the financial industry led to considerable delays in finalizing and implementing the rule. My colleagues at Duke Law, Kimberly Krawiec and Guangya Liu, analyze the origins of the Volcker Rule and detail efforts by the financial industry to influence the final rule in their excellent paper: “The Volcker Rule: A Brief Political History.” Krawiec and Liu note that the Obama administration was originally resistant to the Volcker Rule but eventually came around to supporting it in order to garner the support of liberals who felt that initial drafts of Dodd-Frank were too lenient on big banks. Facilitating the rule’s adoption, no doubt, was the stature of its namesake and brainchild, former Federal Reserve Chairman Paul Volcker. Volcker is widely respected on both sides of the aisle; by Republicans for tackling inflation in the 1980’s, and by Democrats for his willingness to stand up to the big banks.

Critiques and Lobbying Efforts

From the beginning, critiques of the Volcker Rule were relentless, and generally took the form of one, or both, of the following arguments:

• It is extremely difficult to differentiate proprietary trading from standard market making activity or hedging, and any attempt to do so by regulators would involve unnecessary complexity and considerable compliance costs; and
• Banning proprietary trading would reduce market liquidity, making it more expensive for investors to buy and sell securities, and depressing asset prices even further during periods of market stress.

The financial industry had numerous opportunities to express their concerns about the Volcker Rule in the period between Dodd-Frank’s signing in July 2010, to the rule’s final regulations being issued in December 2013. Between the bill’s signing and the release of the Notice of Proposed Rule Making (NPRM) in October 2011, Krawiec and Liu found that the financial industry met with federal agencies to discuss the Volcker Rule close to 400 times (out of 450 total meetings to discuss the rule with agencies). The financial industry ramped up their lobbying efforts after release of the NPRM, meeting with federal agencies to discuss the Volcker Rule over 730 times before the final rule was issued in December 2013.

Bank lobbying efforts resulted in a final rule that was significantly watered down from what the rule’s supporters originally envisioned. Former Senator Ted Kaufman called the final rule “one of the great pieces of Swiss cheese in regulatory history.” Big banks were also able to buy themselves more time to comply with the rule’s provisions. The final rule required banks to be fully compliant by July 21, 2015, although they had to start reporting quantitative trading metrics in July 2014. However, in December 2014, the Federal Reserve announced it was granting banking entities an extension until July 2017 to meet the rule’s ownership interests provision. And just last month, the Fed announced banks could request an additional five years beyond the July 2017 deadline to divest investments in “illiquid funds.” Regardless of the merits of the banks’ arguments against the Volcker Rule, it is clear their lobbying helped shape the contents of the final rule and the timeline for its implementation

Impact on Bank Riskiness

The logic behind the Volcker rule was quite simple: financial institutions shouldn’t be allowed to speculate in financial markets and expect taxpayers to bail them out when their bets go south. This implies that by outlawing proprietary trading and restricting banks’ abilities to invest in hedge funds and private equity funds, banks will become less risky, and less likely to require a bailout. However, there are many ways for a bank to take risk, and just like whack-a-mole, when you restrict one way, banks tend to ramp up risk-taking in other parts of their business.

In a paper that came out this past fall in Management Science, Jussi Keppo and Josef Korte found evidence that bank holding companies (BHCs) overall risk levels did not decline after passage of the Volcker Rule, most likely as a result of reduced hedging of BHCs banking business and an increase in trading book risks. Keppo and Korte did find that BHCs reduced the size of their trading books (relative to total assets) after passage of the Volcker Rule, which is what you’d expect. But just like a game of whack-a-mole, BHCs increased risk-taking in other areas. According to Keppo and Korte: “If the reduction of banks’ overall risk was an essential target of the Volcker Rule, our findings suggest that the rule has so far not been effective.”

Impact on Market Liquidity

Since the beginning, the most common critique of the Volcker Rule is that it will lead to a reduction in market liquidity by making banks less willing to engage in traditional market making activity. The final rule did include an exemption for market making activity, and Krawiec and Liu found that it was this exemption that solicited the most comments in the run-up to the rule’s finalization, with the majority of commenters disputing the banks’ assertions that the rule could hinder market liquidity.

Concerns over market liquidity have not gone away; a number of market participants have been calling attention to increased difficulty in trading large blocks of securities. Regulators have taken notice of these complaints, and have conducted a number of studies attempting to identify any changes to market liquidity and their associated causes. For the most part, the results have been inconclusive. In their most recent report to the G20 on the implementation and effects of financial regulatory reforms, the Financial Stability Board found that: “It is difficult to reliably attribute changes in market liquidity conditions in different segments, if any, to specific drivers.”

However, new research by Federal Reserve economists Jack Bao and Alex Xhou, and Cornell University’s Maureen O’Hara, has given fresh ammunition to those who argue that the Volcker Rule reduces market liquidity. Their paper notes that insurance company capital requirements limit the amount of assets that can be invested in speculative grade bonds. Thus, whenever a bond is downgraded to speculative-grade, you have a large number of investors (insurance companies) who are forced to sell. By looking at the price impact—essentially the cost to execute a trade—during these forced selling episodes over time, Bao, Xhou, and O’Hara were able to isolate the impact of the Volcker Rule on fixed-income market liquidity. Their results show that “bond liquidity deterioration around rating downgrades has worsened following the implementation of the Volcker Rule” and that these results cannot be explained by higher capital requirements as mandated by Basel III and supervisory stress testing (CCAR).

How are Regulators Enforcing the Volcker Rule?

Recall that another prominent critique of the Volcker Rule is that it is too complex to enforce. Many believe that regulators simply do not have the capabilities to differentiate proprietary trading from permitted activities such as market making, hedging, or trading on behalf of clients. To help make this distinction, the final rule authorized regulators to collect a number of different metrics from affected institutions. Specifically, the final rule requires banks to report—for each trading desk—seven different quantitative metrics: (I) risk and position limits and usage; (2) risk factor sensitivities; (3) value-at-risk (VaR) and stress VaR; (4) comprehensive profit and loss attribution; (5) inventory turnover; (6) inventory aging; and (7) customer facing trade ratios. Regulators have been collecting this data since July 2014— one year prior to the rule’s effective date—and in the final rule agencies committed to “evaluate the data collected during the compliance period both for its usefulness as a barometer of impermissible trading activity and excessive risk-taking and for its costs.” Thus far, agencies have given no indication that they have conducted this analysis, nor have they commented on how the data is being used to enforce compliance with the Volcker Rule. Their silence lends credence to the argument that regulators simply don’t have the ability to enforce the Volcker Rule’s proprietary trading ban.

The Volcker Rule’s Future

Shortly after being nominated to be President-elect Trump’s Treasury Secretary, Steve Mnuchin was asked about the Volcker Rule during an appearance on CNBC. He replied that “the number one problem with the Volcker Rule is it’s too complicated and people don’t know how to interpret it.” Given the recent evidence, that’s a generous assessment. House Republicans have also taken aim at the Volcker Rule. The Financial Choice Act, sponsored by House Financial Services Committee Chairman, Rep. Jeb Hensarling (R., Texas) would repeal the Volcker Rule in addition to getting rid of most of Dodd-Frank’s other requirements. If Republicans in Congress ever coalesce around a plan to repeal or replace Dodd-Frank, it’s safe to assume it will include the elimination of the Volcker Rule.

But it may not require legislation to end the Volcker Rule. Regulatory agencies could simply refuse to enforce the rule, which is effectively what’s begun to happen. Mr. Trump has nominated veteran Wall Street Lawyer Jay Clayton to be the next SEC Chair, and will soon nominate individuals to fill the two open positions on the Federal Reserve Board of Governors—including someone to fill the role of Vice-chair for banking supervision—as well as a new CFTC Chair. Once installed in their positions, these individuals will be able to influence how aggressively their agencies enforce the Volcker Rule. This does not mean banks will ramp up their proprietary trading desks and return to the pre-crisis go-go days; capital regulations will still make it expensive for banks to hold large trading positions, particularly in less liquid instruments. But it will lower bank compliance costs and free up resources, within banks and regulatory agencies, to focus on more salient risks. Politics created the Volcker Rule, and politics will likely kill it. And killing it is good policy.

 

 

[1] The Volcker Rule constitutes Section 619 of the Dodd-Frank Act, which serves as an amendment to the Bank Holding Company Act of 1956