What Remains of the Volcker Rule in the New Banking Legislation

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by Matthew Richardson, Roy C. Smith and Ingo Walter

As part of any effort to seriously address excessive systemic risk, the logic of limiting government guarantees to core banking activities - and segregating non-banking risk-taking businesses - is fundamentally sound and in the public interest. This is especially true if other efforts to bolster safety and soundness, like increases in capital buffers, are delayed in a fragile economy or eventually end-run by the banks.

While we do not favor breaking up of the large, complex financial institutions based on arbitrary size restrictions, we do favor market concentration limits as a matter of competitive structure as well as systemic risk exposure. We also support targeted scope restrictions on functional activities conducted by systemic financial firms, essentially in line with the Volcker Rule as originally proposed. There have been two alternatives.

One is to require a complete separation of proprietary trading and asset management businesses - activities that facilitate high-powered and opaque risk-taking and are also highly cyclical - from commercial banking operations, which have access to government-guaranteed deposits and lender of last resort support in crises, and which provide financial intermediation services to the real economy. Any commingling of these activities is harmful to the public interest.

The second is to assess guarantee insurance premiums on financial conglomerates that encompass commercial banks - premiums which are commensurate with the systemic risk contributions of their various activities, and then let financial firms break themselves up organically if they find it profitable to do so. This approach considers that commingling of different activities may be socially desirable for some firms but not for others, and faced with higher premiums for riskier activities, the latter (or some of them) may carve-out these activities as a matter of strategic redirection. 

While the commingling of commercial banking with investment banking activities such as underwriting and market-making was ruled out in the financial reforms of the 1930s, such commingling did not contribute to the recent financial crisis. The Volcker Rule, as originally proposed, banning proprietary trading and sponsoring hedge funds and private equity funds by firms benefiting from access to the government safety net, was significantly watered down in the Financial Reform and Consumer Protection Act of 2010, which has now been passed by both houses of Congress. 

We supported the original Volcker proposals as the best chance for limiting the spillovers and systemic risk by banning proprietary trading, correctly defined, and prohibiting banking conglomerates sponsoring and investing in proprietary hedge funds and private equity funds. We continue to believe this approach makes a lot of sense, tailored to modern financial products and markets, when combined with the ready availability of financial specialists to conduct proprietary activities in a way that can be effectively regulated. It is an initiative unlikely to trigger significant social costs in terms of financial efficiency, innovation and competitiveness. Indeed, based on a careful analysis of the unintended consequences of the Glass Steagall restrictions of 1933, quite the opposite could well turn out to be the case.

In the event, only a mild version of the Volcker Rule survived the legislative process and allows banks to continue proprietary trading in certain public obligations as well as sponsorship with limited equity interest of hedge funds and private equity funds. It seems to us like a defensible second-best solution. The same is true of the limited requirement for trading high-risk derivatives through separately capitalized subsidiaries. Whether these reforms are robust enough to withstand the next crisis remains to be seen.

So the legislating breakup of systemically important large, complex financial institutions didn't happen this time around - institutions that many observers believe to be not only too big to fail, but also too big to management and too big to regulate. So the structural basis for significant systemic risk exposure in the US financial system likely to remain pretty much as before, which places an enormous premium on the other safeguards built into the Financial Reform and Consumer Protection Act of 2010. They had better work.

The key benefit of this week's US regulatory outcome, despite its limitations and loopholes, is that it may cause key firms to rethink their business models and the population of less systemic financial specialists in the financial system will increase. Chances are the surviving businesses would be far simpler and their accounts far more transparent (and more easily subject to regulation) than those of today's dominant financial conglomerates. This, in turn, would give banking regulators a better shot at understanding and containing the risks that might result in future bailouts. As well, financial conglomerates ability to abuse government guarantees intended for one activity by supporting riskier ones will be limited - so that the endemic problem of government guarantees' compromising market discipline and engendering future crises will have been alleviated.

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The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

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