As the provisions of the Dodd-Frank financial regulatory law begin to go into effect, federal oversight agencies have issued the first draft of the “Volcker Rule.” Named for former Federal Reserve chairman Paul Volcker, the Volcker Rule says that commercial banks shouldn’t be able to make risky bets with federally insured deposits. The Roosevelt Institute’s Mike Konczal talked to The Nation about what the Volcker Rule is and why it’s necessary. Here’s Mike:
The Volcker Rule is best understood as an attempt to update the New Deal–era Glass-Steagall for the twenty-first century. Glass-Steagall called for a complete separation of investment banking—the activities of underwriting and dealing with stocks and debt—from deposit taking. Consistently weakened from the 1980s onward, Glass-Steagall was fully repealed in the late 1990s to allow Citicorp to merge with an insurance company.
The Volcker Rule seeks to keep activities essential to banking within a safety net, while excluding other, riskier, activities from this safety net. There are a variety of special regulations, and protections, banks get, ranging from federal deposit insurance (known as FDIC) to access to the Federal Reserve’s discount borrowing window, designed to keep the system working through panics. Banks currently engage in a wide variety of non-banking activities with safety net protection. For example, they speculate in currencies and run hedge funds and proprietary trading desks for their own benefit. These activities made the financial crisis worse; one estimate has the major Wall Street firms suffering $230 billion dollars in prop trading losses a year into the crisis. And right now, these activities are subsidized by access to the banking safety net.
The New York Times says, “A main element to the plan would bar banks from making proprietary trades—using their own money to place directional market bets that are unrelated to serving customers.” Can you break this down for us?
Proprietary, or “prop,” trading are directional bets made for a firms’ own accounts, with their own resources, for their own gain. This is different from trades done for clients on commission. Under a strong Volcker Rule, any securities market activities would have to be intended to serve customers—not market-making bets for the bank’s own profits. Prop trading is very common among the largest financial institutions, many of which were bailed out during the 2008 financial crisis, and among the firms that are targeted by Dodd-Frank. These large, systemically risky firms are also a big presence in hedge funds and private equity operations. Bank-affiliated funds were responsible for over a quarter of private equity investments over the past thirty years. Bear Sterns ran two hedge funds. Its collapse, the first major collapse of the financial crisis, resulted in part from those two hedge funds experiencing spectacular losses over a short time window.
Many financial regulations are aimed at leveling the playing field between two agents. For example, making sure your bank isn’t misleading you on the terms of a mortgage is an important part of regulations after Dodd-Frank. The Volcker Rule helps with the conflicts of interest between banks and their clients. But it also provides for the stability of the economy as a whole. The financial system has the ability to disrupt a huge part of the economy in a panic. The Volcker Rule, by removing the “casino” part of the financial system from the core banking parts, will make panics less likely and more manageable when they do.
Don’t actions taken in the bank’s benefit ultimately benefit customers—and/or shareholders?