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Volcker Rule Definition
The Volcker Rule is the common name for section 13 of the Bank Holding Company Act of 1956. It is a federal regulation that prohibits banks as well as institutions that own banks from conducting proprietary trading activities from their own accounts. The Volcker Rule also interdicts certain relationships with hedge funds and private equity funds. The institutions affected by the Volcker Rule are (1) Insured depository institutions (2) Companies that control insured depository institutions (3) Companies that are treated as bank holding companies.
The Volcker Rule was first introduced in section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and was named after Paul Volcker, former Chairperson of the Federal Reserve. In the wake of the financial crisis of 2008, the Federal Reserve felt the need to devise regulation in order to protect bank customers by prohibiting banks from conducting specific types of speculative investments. The result was the Volcker Rule, the final version of which became effective on April 1, 2014.
A Little More on What is the Volcker Rule
The “Agencies” — a group of financial services regulators such as the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission and the Securities and Exchange Commission officially adopted the final version of the Volcker Rule on December 10, 2013. The regulators offered a conformance period with a deadline of July 21, 2015 to banks and bank owners to come into compliance with the prohibitions imposed by the Volcker Rule on proprietary trading as well as ownership and sponsorship of covered funds.
Section 13 has specific provisions to prohibit banks and insured depository institutions from conducting short-term proprietary trading of financial instruments as well as options based on such instruments from their own accounts. The Volcker Rule specifically prohibits the trade of securities, derivatives and commodity futures while additionally placing interdictions on the acquisition or retention of ownership interests in investment funds such as hedge funds and private equity funds. However, there exist certain exemptions that make it possible for banks to invest in specific investment funds from their own accounts. Moreover, banks retain the right to approach the Federal Reserve for an extension of the transition time to come into full compliance of the Volcker Rule for certain undertakings and investments.
Why is the Volcker Rule Necessary?
The rationale behind the implementation of the Volcker Rule is that when banks engage in proprietary trading activities, it can create several complications such as:
- A material conflict of interest, since the bank now has material interest, financial or otherwise, in certain investments.
- Expose the bank to assets or trading strategies that are typically high-risk in nature, thus potentially affecting the business in unforeseen or undesired ways.
- Trigger instability within the bank. In fact, the entire U.S. financial system may be rendered vulnerable to such instabilities when major banking institutions are affected.
The Volcker Rule makes it mandatory for banks to report to the Federal Reserve all their activities pertaining to trading. Additionally, larger banks and financial institutions are required to implement certain programs to ensure that they are fully compliant with the new rules. These programs can be independently tested and analyzed for effectiveness.
A Brief History of the Volcker Rule
With its appalling combination of financial crisis and deep recession, the Great Recession in the United States (December 2007 – June 2009) dealt a severe blow to the economy of the country. Unemployment rose to alarming levels and the gross domestic product (GDP) of the country witnessed a steep decline. A post-crisis assessment conducted by the U.S. Financial Crisis Inquiry Commission in 2011 concluded that the recession was, in fact, avoidable and that the Federal Reserve’s inability to contain “toxic” mortgages was partly responsible for the crisis.
Nevertheless, at the behest of then Federal Reserve Chairman Paul Volcker, section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act came into force, gaining publicity in popular media as the “Volcker Rule”. Originally planned to be implemented as part of the Dodd-Frank Act on July 21, 2010, the implementation of the Volcker Rule was delayed by several years until it was finally given the go-ahead by the pertinent agencies on December 10, 2013.
April 1, 2014 was scheduled as the date on which the Volcker rule would go into effect. However, in consideration of a lawsuit filed by community banks over provisions pertaining to specialized securities, a revised final version of the rule was formally adopted on January 14, 2014. This final iteration of the Volcker rule came into effect after more than a year on July 21, 2015.
Jerome Hayden “Jay” Powell was nominated to the Chair of the Federal Reserve by President Donald Trump in February, 2018. Almost immediately upon assuming this responsibility, Powell along with other members of the Federal Reserve Board undertook certain initiatives in order to simplify and streamline the requirements pertaining to the Volcker Rule. Their proposal was to reduce the number of restrictions associated with the regulation as well as reduce the costs of compliance for qualified banks.
References for “Volcker Rule”
Academic research for “Volcker Rule”
The Volcker Rule and evolving financial markets, Whitehead, C. K. (2011). The Volcker Rule and evolving financial markets. Harv. Bus. L. Rev., 1, 39.
Large banks and the volcker rule, Acharya, V. V., Cooley, T. F., Richardson, M., & Walter, I. (2011). Large banks and the volcker rule. Regulating Wall Street, 181.
The Volcker rule and market-making in times of stress, Bao, J., O’Hara, M., & Zhou, X. A. (2016). The Volcker rule and market-making in times of stress. Journal of Financial Economics (JFE), Forthcoming.
The Volcker Rule and corporate bond market making in times of stress, Bao, J., O’Hara, M., & Zhou, X. A. (2018). The Volcker Rule and corporate bond market making in times of stress. Journal of Financial Economics, 130(1), 95-113.
Investment bank power and neoliberal regulation: from the volcker shock to the volcker rule, Hager, S. B. (2012). Investment bank power and neoliberal regulation: from the volcker shock to the volcker rule. In Neoliberalism in crisis (pp. 68-92). Palgrave Macmillan, London.
Creating a Future Economic Crisis: Political Failure and the Loopholes of the Volcker Rule, Gary, A. K. (2011). Creating a Future Economic Crisis: Political Failure and the Loopholes of the Volcker Rule. Or. L. Rev., 90, 1339.
The expressive synergies of the Volcker Rule, Dombalagian, O. H. (2013). The expressive synergies of the Volcker Rule. BCL Rev., 54, 469.