Regulation & Reform

What is the Volcker Rule?

CROSS POST—-Posted on December 10, 2011 by

What is popularly referred to as “The Volcker Rule” is actually Section 619 of the Dodd-Frank Act, which was passed in 2010 and aims to regulate Wall Street. Its official title is “Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds.”The Volcker Rule bans proprietary trading (i.e. speculation) and investments in hedge funds at government backstopped banks.

The concern behind the Volcker Rule is that banks have used depositors’ funds from FDIC-insured checking and savings accounts, as well as access to virtually free money from the Federal Reserve, in order to take extremely risky bets in the financial markets.  When these bets fail, they leave bank depositors and the American taxpayer holding the bag.

Similar concerns arose during the Great Depression of the 1930’s, leading to the passage of the Glass-Steagall Act, which required retail banks to be separate from investment banks.  Unfortunately, in the 1990’s, federal regulators and Congress buckled under pressure from the banking lobby and gradually repealed Glass-Steagall.  The final death-knell of Glass-Steagall came in the form of the Gramm-Leach-Bliley Act.  The proposed Volcker Rule attempts to approximate the restrictions of Glass-Steagall. However, there are a large number of exceptions to the rule in the current draft, which we believe has the potential to be abused by the banks.

Why is it called “The Volcker Rule”?

The Volcker Rule is named after Paul Volcker, who served as the Chairman of the Federal Reserve from 1979-1987. Following the financial crisis of 2008, Volcker wrote a three-page memo to President Obama where he argued that to avoid a similar crisis in the future, one approach would be to eliminate proprietary trading at and ownership of hedge funds by the big banks.

Is the Volcker Rule in effect now?

The Volcker Rule is not currently in effect. That is because Section 619 passed the task of writing the actual implementation of this new rule on to the regulators (the SEC, the Federal Reserve, and others). The regulators released their draft in October 2011, and the public has until January 13th, 2012 to submit comments on this draft. All comments become a part of the public record, and can be viewed online. After the comment period, the regulators will create the final rule, taking into account the comments received. The final rule is scheduled to go into effect on July 21st, 2012.

What does the Draft Volcker Rule Say?

The Draft of the Volcker Rule that the SEC and the banking regulators have prepared does ban proprietary trading at banks, and prevents them from owning hedge funds, but it makes many exceptions to these broad bans. Here are just a few:

  • Banks are still allowed to perform underwriting and market-making.
  • They are allowed to have up to a 3% ownership interest in a hedge fund.
  • In the first year of a hedge fund, that 3% limit does not apply.
  • The trading of repurchase agreements (called repos for short) is given a blanket exemption.

These exceptions, in their current form, are so broad that they have the capacity to essentially nullify the Volcker Rule’s main restrictions.