Why the Volcker Rule won't solve the problem of Too Big To Fail

Or any problems, really...

(Image credit: (Mark Wilson/Getty Images))

The Volcker Rule was originally proposed to end the problem of banks needing taxpayer bailouts. Paul Volcker, the former chairman of the Federal Reserve, proposed that commercial banks using customer deposits to trade — a practice known as proprietary trading — played a key role in the financial crisis that began in 2007.

Five former Secretaries of the Treasury — W. Michael Blumenthal, Nicholas Brady, Paul O’Neill, George Shultz, and John Snow — endorsed the Volcker Rule in an open letter to the Wall Street Journal, writing that banks "should not engage in essentially speculative activity unrelated to essential bank services."

The Volcker Rule was signed into law as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act in July of 2010, but its implementation has been delayed until yesterday when it finally received approval from the five (!) regulatory agencies that will enforce it — the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC).

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President Obama has strongly endorsed the Volcker Rule, claiming:

The Volcker Rule will make it illegal for firms to use government-insured money to make speculative bets that threaten the entire financial system, and demand a new era of accountability from CEOs who must sign off on their firm's practices. [whitehouse.gov]

Now, restricting banks’ abilities to make speculative bets with their customers’ money is an interesting idea. It was at the core of the Glass-Steagall Act which was created as a response to the Wall Street Crash of 1929. Glass-Steagall forced a separation between retail banking and investment banking. Banks accepting deposits from retail customers could not get into trading and underwriting the issue of securities. And investment banks could not get into the business of accepting retail deposits.

The idea is to have a two-tier banking sector: A non-risk-taking part, which accepts retail deposits and benefits from deposit insurance, and a risk-taking-part, which does not accept retail deposits and does not benefit from deposit insurance. The Volcker Rule attempts to update this separation for the 21st century by restricting the speculative activities of all Federally insured banks, but without any explicit separation between retail and investment sectors.

Proponents of a separation note that the United States was mostly free from financial crises during its lifespan from the 1930s to 1999, when it was repealed. Critics say that such a separation does not necessarily prevent retail banks from engaging in high-risk speculation with customers’ money, and does not end the problem of Too Big To Fail because retail banks and investment banks still owe money to each other, so a collapsing investment bank can still cause a lot of damage to the wider system.

This is an interesting debate, although I don’t really think that it has anything to do with the problem of Too Big To Fail, which is more of a problem of interconnectivity between financial institutions. If a large institution owes lots of money to other institutions and then runs out of money and defaults on its obligations, it will cause problems in the financial sector regardless of whether that institution is a retail bank, an investment bank, or another institution entirely (like a hedge fund or a mutual fund).

Unfortunately, such a debate is meaningless because the Volcker Rule has too many huge loopholes to be considered effective. That's true even if you think the way to prevent Too Big To Fail is by preventing financial speculation from using customers’ funds.

There appear to be four main exemptions built into the rule that basically render it useless:

1. Market making

Large banks that sell securities to clients like to keep a cache of securities on hand to sell to clients. This is much quicker and easier than having to go to the open market to purchase securities every time a client makes an order, but it also lets them profit from prices differences between each sale.

2. Hedging

Banks would be allowed to buy securities to balance their positions against specific, identifiable risks of other banking activities and other positions. Banks would be required to conduct analyses supporting its hedging strategy, and the effectiveness and rationale of hedges must be monitored by regulators. But they can still do it.

3. Foreign Banking Entities

The foreign operations of U.S. entities may engage in exempt transactions. Given that most large banks are global operations, it means that any desired risky and speculative activities can simply be done outside the United States.

4. Government securities

Banks would be able to continue to engage in proprietary trading in U.S. government, agency, state, and municipal obligations. They also would permit, in more limited circumstances, proprietary trading in the obligations of a foreign sovereign or its political subdivisions.

These loopholes leaves a huge amount of scope for banks to justify speculative activities. But they're also confusing for banks trying to understand what they can and cannot do. Jamie Dimon, the CEO of JPMorgan Chase, half-joked that every trader would need a psychologist and a lawyer by his side to make sure he wasn’t violating rules.

This may be good news for psychologists and lawyers, but it’s not good news for an American public trying to avoid further bank bailouts. Or indeed for banks who will spend a lot of time, effort, and money complying with (or loopholing) the new regulations that might instead be spent more productively.

Essentially, then, the Volcker Rule does not even do what it claims to do. It will not stop proprietary trading. And it will not end the reality of banks that engage in speculative behavior being eligible for taxpayer bailouts.

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