The Volcker Rule prohibits banks from using customer deposits for their own profit. It also won't let them own, invest in, or sponsor hedge funds, private equity funds, or other trading operations for their own use. It protects depositors from the types of speculative investments that led to the 2008 financial crisis. The rule is section 619 of the Dodd-Frank Wall Street Reform Act of 2010.
What Is the Volcker Rule?
Under the Volcker Rule, banks can no longer trade securities, derivatives, commodities future, and options for their own account. This is called proprietary trading. It limits their investment in, and relationships with, hedge funds or private equity funds.
Bank CEOs must annually attest in writing that their firm is complying with the rule.
The Volcker Rule allows trading in two circumstances.
Banks can trade when it's necessary to run their business. These include market-making, underwriting, hedging, and trading if it is to limit their own risk. For example, they can engage in currency trading to offset their foreign currency holdings. They may also hedge interest rate risk.
Banks may also act as agent, broker, or custodian for their customers. It allows banks to trade on behalf of their customers with the client's approval. Sometimes, this means banks must have some of their own "skin in the game."
Banks cannot engage in any trading activities that might create substantial risk.
They cannot trade if doing so would create a conflict of interest. They can't expose the bank itself to high-risk trades. Most of all, they can't generate instability to the U.S. financial system.
How the Volcker Rule Was Implemented
Congress passed Dodd-Frank and the Volcker Rule in 2010. It gave the job of developing the law into specific regulations to a commission of five agencies. They continue to oversee the regulations today. They are:
- Federal Reserve
- Commodities Futures Trading Commission
- Federal Deposit and Insurance Corporation
- Office of the Comptroller of the Currency, a division of the Treasury Department
- Securities and Exchange Commission
On December 10, 2013, the commission completed the regulations. On Jan. 31, 2014, it announced the regulations, giving the banks a year to prepare. As a result, the Volcker Rule has been in force since July 21, 2015.
On May 30, 2018, the Fed voted to offer banks compliance relief. On June 25, 2020, the U.S. Securities and Exchange Commission released the final rule modifying the Volcker Rule. It addressed three areas:
- Clarified the prohibition against banks' use of hedge funds and private equity funds
- Limited the impact of the Volcker rule on banks' foreign activities
- Permitted specific non-risky activities that had been banned by the Volcker Rule
The Volcker Rule seeks to undo the damage done when Congress repealed the Glass-Steagall Act in 1999. It had separated investment banking from commercial banking.
Under Glass-Steagall, investment banks were privately-run, small companies that helped corporations raise capital by going public on the stock market or issuing debt. They charged high fees, stayed small, and didn’t need to be regulated.
Commercial banks were safe places for depositors to save their money and gain a little interest. They lent the funds at regulated interest rates. Commercial banks made money despite thin profit margins because they had access to lots and lots of capital in the depositors' funds.
Congress repealed Glass-Steagall with the Gramm-Leach-Bliley Act in 1999. Banks wanted restrictions lifted so they could be internationally competitive. Retail banks, like Citi, started trading with derivatives like investment banks.
The repeal of Glass-Steagall meant banks could now put the vast reserves of depositors' funds to work without much regulation to worry about.
They could do so knowing that the federal government didn’t protect investment banks as much as commercial banks. The FDIC protected commercial bank deposits. Banks could borrow money at a cheaper rate than anyone else. That's called the LIBOR rate. It’s just a hair above the fed funds rate.
This situation gave the banks with an investment banking arm an unfair competitive advantage over community banks and credit unions. As a result, big banks bought up smaller ones and became too big to fail. That’s when the failure of a bank would devastate the economy. A too-big-to-fail bank will likely need to be bailed out with taxpayer funds too big to fail. That added another benefit. The banks knew the federal government would bail them out if anything went wrong.
Banks had the taxpayers as a safety net as both depositors and a source of bailout funds.
That's called a moral hazard. If things went well, bank stockholders and managers won. If they didn’t, taxpayers lost.
Five Ways It Affects You
The Volcker Rule impacts you in the following five ways:
- Your deposits are safer because banks can't use them for high-risk investments.
- It's less likely that banks will require another $700 billion bailout.
- Big banks won't own risky hedge funds to improve their profit.
- Your local community bank now has a better chance to succeed and not get .bought out by a big bank. This will help small businesses.
- It's less likely that a company like Lehman Brothers will fail.
Who the Volcker Rule Is Named After
The Volcker Rule was proposed by former Federal Reserve Chairman Paul Volcker. At the time, he was the chair of President Barack Obama's 2009-2011 economic advisory panel. When Volcker was Fed Chairman, he courageously raised the fed funds rate to uncomfortable levels to starve double-digit inflation. Although this helped cause the 1980-1981 recession, it was successful.