Volcker’s rule helped US emerge from the 2008 crisis. Why is it in trouble now?

By Priya Kumari

After the unexpected fall-out of US Presidential elections, lobbyists from big U.S. banks have begun discussing the rollback of Volcker Rule. The rule is against the usage of depositor’s funds for speculative bets on the bank’s own account.

This is a foreseeable outcome after Donald Trump announced his plans to replace the Dodd-Frank Act with new policies to encourage growth.

Limiting that which does not benefit the economy and the people

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Volcker Rule is the brainchild of the former United States Federal Reserve Chairman and renowned economist, Paul Volcker. It was proposed with an intent of preventing the United States banks from making certain kinds of speculative investments that don’t benefit their customers and the economy.

The aim of the rule is to prohibit and subject to exceptions – a banking entity from engaging in proprietary trading, from acquiring or retaining an ownership interest in, or sponsoring a hedge fund or private equity fund.

However, certain practices like underwriting activities and those related to market-making and risk-mitigating hedging are expressly permitted.

Whom does it apply to?

It applies to any insured depository institution or company that controls such an institution. Furthermore, it also targets foreign banking organisations (FBOs) that have branches or subsidiaries in the US.

However, for non-US banking organisations, the Rule would apply only for proprietary trading and fund activities in the US. Also to activities outside the US, if they involve the offering of securities to any US resident.

[su_pullquote]The commercial banking system is essential to the stability of the entire financial system. [/su_pullquote]

Paul Volcker’s rationale behind this was that by engaging in high-risk speculations, banks pose a significant systemic risk. The commercial banking system is essential to the stability of the entire financial system. In light of this, the Volcker rule was seen as a preventive measure when President Obama announced his intention to end the mentality of “too big to fail” in January 2010.

So, what’s the big fuss about proprietary trading?

Generally, banks make thin-margin commissions by processing trades for the clients. Proprietary trading happens when a bank decides to profit from the market by investing money from the organisation’s own capital and balance sheet.

Besides making huge profits, banks gather an inventory of securities on their books, thereby making them capable of offering these securities to the clients in otherwise unfavourable circumstances. This positions the financial firm as a stable market-maker by providing liquidity on specific set of securities.

All seems well until one investigates the intriguing facets of proprietary trading. There may be a conflict of interests between the bank and its customers. Since investment banks play an important role in mergers and acquisitions, there is a chance that traders might use inside information to engage in merger arbitrage.

What are the banks saying?

Banks are arguing that proprietary trading desks can sometimes act as a market-maker. In circumstances, when a client wants to trade a large amount of a single security or trade a highly liquid security – the proprietary trading desk could potentially act as the buyer or seller since there aren’t other parties to facilitate the trade.

US banks are gearing up to fight Dodd-Frank Act’s Volcker Rule. | Source: The Fiscal Times

This makes it difficult to prove if the banks are speculating or merely serving the clients. Despite being constantly modified, the U.S. banking organisations which are competing with other organisations in delivering effective financial services remain constrained. It also restricts short-term trading strategies by these banks; irrespective of the location of business in cases where those strategies involve instruments specifically prescribed.

The Volcker Rule is inept in terms of designing yardsticks to measure the intentions of the participating firms.

Nevertheless, it certainly makes sense to ensure that the lenders backed by insurance from the government don’t gamble with their balance sheets.

With the business-friendly outlook of the Trump regime, it will be a game of striking a balance. This will be between the risks of letting loose the greedy, unethical spirits of big banks, and the returns of a greater economic growth with more revolutionising functions of the banks in the global financial network.

Featured Image Credits: The Balance
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