The Volcker rule was included in the 2010 Dodd-Frank Act at the behest of former Federal Reserve Chairman Paul Volcker, who argued that banks should not be allowed to speculate with government insured deposits.1 The rule limits the ability of banking entities, acting as dealers, to take risks on their own books by banning so-called proprietary trading and limiting bank investments in covered funds. While the need to curtail excessive risk taking by banking entities in order to prevent a repeat of the 2008 financial crisis is widely acknowledged, as discussed in Duffie2 and summarized in the Final Rule3, the implementation of the Volcker Rule has raised several concerns amongst market participants. Specifically, some have argued that by tying the hands of dealers, the Volcker Rule imposes costs by hampering price discovery and raising price volatility in capital markets, and therefore has a negative welfare impact.
In our recently released paper, we study whether such conventional wisdom about the intensive margin is theoretically robust or not. Our main result is that dealer regulation may lower price quality and dealer profitability while at the same time, if the general equilibrium effect is taken into consideration, it may increase the welfare of other market participants. In the two extensions of the baseline model, we also argue that this novel insight on welfare is robust, while the conventional wisdom about the deteriorating price quality is fragile to the introduction of dynamic inventory management and endogenous information acquisition.
The Cost of Regulation
The price quality deterioration mechanism that we capture is the same as the one widely discussed in the public comments summarized in the Final Rule; if the dealer is not allowed to buffer temporary supply and demand imbalances, the price it quotes has to reflect those imbalances rather than economic fundamentals, and therefore the price becomes less informative and more volatile. Accordingly, expected dealer profit decreases.
However, the welfare implication is opposite to the conventional wisdom. The intuition behind the seemingly counterintuitive welfare result is that in a general equilibrium, somebody has to hold risky assets. If a regulation restricts the dealer’s risk-taking ability, the risky assets held previously by the dealer have to be held by other market participants. The only way for a dealer to induce other market participants to hold risky assets is to quote an attractive price for them, resulting in a welfare redistribution from the dealer to other market participants. At the same time, for other market participants to accept more risk, this welfare redistribution has to be large enough to make them better off.
Our welfare analysis deepens the debate on dealer regulation by identifying who bears the cost of the regulation. The typical discussion of dealer regulation focuses on the trade-off between the benefit from lower systemic risk and the cost due to efficiency losses created by dealer constraints. Our paper elaborates on the discussion of the cost by identifying dealers as the only group of market participants who bear the cost. This is different from the view in the Final Rule that all market participants might be worse-off. The upshot is that even though all other non-dealer market participants face a less informative and more volatile price, they can be better off under the new rules.
Price Volatility and Price Informativeness
In addition to the welfare gains, we also consider the robustness of the conventional wisdom on price quality. Specifically, we argue that the conventional wisdom on the price quality deterioration is theoretically fragile, i.e., the dealer regulation might decrease the price volatility and increase the price informativeness.
The typical argument around price volatility holds that if the dealer cannot take the inventory risk, it has to adjust the price more often to manage the riskiness of its inventory, thereby increasing price volatility. Our paper argues that this conclusion is a consequence of the exogenous inventory risk assumption. In an environment where the dealer’s inventory is endogenously determined, e.g., dynamic inventory management, as the dealer becomes more risk averse in response to a given regulation, the dealer reduces its holdings of risky assets. Since the absolute amount of risk in the dealer’s inventory decreases, the dealer does not have to frequently adjust prices, so the price volatility may decrease. In this sense, the concern around the Volcker Rule’s contributions to price volatility might be fragile to the introduction of an endogenous inventory risk assumption.
For price informativeness, the typical argument holds that if the dealer pursues inventory stability more than expected profit, the quoted price reflects less information about the security’s fundamentals and more about the noise of the dealer’s inventory. Our paper argues that such a conclusion is a consequence of the exogenous information acquisition assumption. To be more specific, we consider the same exercise as Grossman and Stiglitz4, in which the market participants can choose whether to invest in information acquisition at some cost and, in equilibrium, the number of the agents who invest is determined such that the welfare of those who invest is equal to those who do not. In this environment, even if the dealer reflects less information in the quoted price as a result of the Volcker Rule, the resulting information advantage of those who have invested to acquire said information increases, which therefore entices more market participants to invest in information acquisition. As a result, price informativeness remains constant (instead of decreases as in the conventional wisdom) no matter how strict the regulation is.
In both of these extensions (price volatility and informativeness), our novel result of improvements in the overall welfare of market participants, other than dealers, survives. Thus, we argue that our analyses not only validates the robustness of our novel welfare implication, but also points to the fragility of the conventional wisdom about price quality. Given that a clean empirical identification is hard to obtain in the context of the Volcker rule, we hope our paper provides a reasonable, and clean, theoretical benchmark that is useful for future policy discussions.
- Paul Volcker. How to Reform Our Financial system. The New York Times, January 2010.
- Darrell Duffie. Market Making Under the Proposed Volcker Rule, January 2012.
- Final Rule. Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, Office of the Federal Register, Vol.79, No. 21, National Archives and Records Administration.
- Sanford Grossman and Joseph Stiglitz. On the Impossibility of Informationally Efficient Markets. The American Economic Review, January 1980.