Six Ways the Volcker Rule Protects You

Why Banks Hate It

Trader on the stock exchange floor
••• Photo by Scott Olson/Getty Images

The Volcker Rule prohibits banks from using customer deposits for their own profit. They can't own, invest in, or sponsor hedge fundsprivate equity funds, or other trading operations for their use. The rule is section 619 of the Dodd-Frank Wall Street Reform Act of 2010

The Rule targets former large investment banks, like Goldman Sachs and Morgan Stanley. These banks became commercial banks during the financial crisis so that they could take advantage of taxpayer-funded bailouts. It also protects depositors in the largest retail banks, like JP Morgan Chase and Citi.

Bank CEOs must personally attest that they are complying with the rule. That applies to everyone down the chain of command. Every bank employee is legally and personally liable if they aren't in compliance.

The Volcker Rule allows trading in two circumstances. First, banks can trade when it's necessary to run their business. For example, they can engage in currency trading to offset their foreign currency holdings. They may also trade to offset interest rate risk. Second, banks can trade on behalf of their customers. They can use client funds only with the client's approval. Sometimes, this means banks must have some of their own "skin in the game." In that case, banks can invest up to 3 percent of their capital.

Current Status

Banks have been required to comply with the Volcker Rule since July 21, 2015. Why did it take five years after Dodd-Frank passed? It was supposed to take effect in July 2012, after two years of review by federal agencies, banks, and the public. But big bank lobbyists had delayed it. On December 10, 2013, a five-agency commission approved it. In April 2014, they gave the banks a year to prepare. That was three years after Dodd-Frank passed. 

Changes are already coming from the commission who implemented the law. The five members are Securities and Exchange Commission, the Federal Reserve, the Commodities Futures Trading Commission, the Federal Deposit and Insurance Corporation, and the Office of the Comptroller of the Currency, a division of the Treasury Department.

On May 30, 2018, the Fed voted to offer banks "compliance relief." Banks are allowed to trade for their own purposes. But it's difficult for regulators to tell whether a trade is speculative or not. The Volcker Rule made the banks prove the trade wasn't speculative. The Fed's proposal makes regulators prove the trade is speculative. That shifts the burden from the banks to regulators. The other members of the commission are expected to follow the Fed's vote.

The Trump administration wants to reduce the rule's scope. On June 13, 2017, a U.S. Treasury Department report suggested exempting banks with less than $10 billion in assets. Congress has been deliberating a bill to that effect. But large banks have also been lobbying for changes. 

Banks want more freedom to engage in trades that last less than 60 days. Under the Rule, they must prove the trades are for clients. They want to exempt some overseas funds from the Rule. Banks also want more freedom in trading for their wealth management division.

Why It's Needed

The Volcker Rule seeks to undo the damage done when Congress repealed the Glass-Steagall Act. Glass-Steagall was simple. It 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 boring, safe places where depositors could put their money and gain a little interest. They could take out loans 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.

Banks lobbied to repeal Glass-Steagall so they could be internationally competitive. Retail banks, like Citi, started trading with derivatives like investment banks. That meant the CEOs 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.

Impact on Banks

Banks could lose $10 billion in profit, according to Standard & Poor's. In response to the Volcker Rule, Goldman Sachs reduced its risk-taking in 2011. That's when it closed Goldman Sachs Principal Strategies, a division that traded equities, and the Global Macro Proprietary Trading desk, which made risky trades with bonds, currencies, and commodities.

Goldman also reduced investments in private equity and hedge funds to 3 percent or less of each fund. That's good because these investments caused Goldman’s second quarterly loss since going public in 1999. 

Six Ways It Affects You

The Volcker Rule impacts you in the following six ways:

  1. Your deposits are safer because banks can't gamble them away. 
  2. It's less likely that banks will require another $700 billion bailout.
  3. Big banks will no longer be able to use risky hedge funds to improve their profit.
  4. Your local community bank now has a better chance to succeed and not get bought out by a big bank. Community banks are more likely than big banks to lend to small businesses.
  5. It's less likely that you'll wake up one morning and find that a company like Lehman Brothers has failed.
  6. At least 35 bankers are in jail. But none of the CEOs of the largest banks have been charged with crimes.

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.