Volcker Rule Summary

6 Ways the Volcker Rule Protects You (and Why Banks Hate It)

••• The Volcker Rule prohibits banks from trading for their own profit. Photo by Scott Olson/Getty Images

Definition: The Volcker Rule prohibits banks from investing your deposits for their own profit. It is part of the Dodd-Frank Wall Street Reform Act of 2010

The Volcker Rule forbids banks from owning, investing in or sponsoring hedge fundsprivate equity funds or any proprietary trading operations for their use. It prevents them from using funds guaranteed by the Federal Deposit Insurance Corporation for hedge funds or private equity funds.

The Rule limits the liabilities that the largest banks can hold. This limitation targeted former 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. The Volcker Rule also seeks to protect 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 some trading when it's necessary for a bank to run its business. For example, banks can engage in currency trading to offset their foreign currency holdings. They may also do some similar kinds of trading to offset interest rate risk.

Banks are still allowed to trade on behalf of their customers, with their clients' funds and approval.

Sometimes, this means the investment requires some "skin in the game." In that case, banks can invest up to 3 percent of their capital.

Current Status

On June 13, 2017, U.S. Treasury Secretary Steve Mnuchin released a report that proposes changes to the Volcker Rule. It seeks to exempt banks with less than $10 billion in assets from the Rule.

The report reflected an executive order signed by President Trump during his first 100 days.

On January 19, 2017, Mnuchin testified in Congress that he supported the Volcker Rule. But he is concerned about how much it limits banks' liquidity. (Source: Congressional Hearings for Treasury Secretary, January 19, 2017.)

Banks have been required to comply with the Volcker Rule since July 21, 2015. They had since April 2014 to prepare. It cost the seven largest "market-making" banks $400 million. The sheer complexity and expense of compliance forced out many international and smaller banks. (Source: "Much Ado About Trading," The Economist, July 25, 2015.)

The Volcker Rule was initially supposed to take effect in July 2012, after two years of review by federal agencies, banks and the public. It was the only piece of Dodd-Frank that had not been put in place. That's because the big bank lobbyists had been trying to delay it. 

On December 10, 2013, the Volcker Rule was approved by representatives of the five agencies who implement it:

  1. The Securities and Exchange Commission
  2. The Federal Reserve
  3. The Commodities Futures Trading Commission
  4. The Federal Deposit and Insurance Corporation 
  5. The Office of the Comptroller of the Currency, a division of the Treasury Department.

    The SEC and the CFTC said the Rule didn't limit banks' risk-taking. As a result, former Treasury Secretary Jack Lew announced the Treasury would require bank CEOs to guarantee that their companies are in compliance. That means they are legally liable for failure to comply.

    Also, the Rule prohibits banks from "portfolio hedging." That means they aren't allowed to offset risks in an asset class by trading. (Sources: "Volcker Rule to Require Bank Chiefs' Guarantee," The Wall Street Journal, December 6, 2013. "Paths Diverge on the Volcker Rule," The Wall Street Journal, November 23, 2013.)

    Why It's Needed

    The Volcker Rule was designed to prevent large banks from becoming 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.

    The 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 boring community banks and credit unions. As a result, these big banks bought up older ones and became 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 of the Volcker Rule

    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 has 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. (Source: "MF Global’s Collapse Exposes Prop-Trading Risk That Volcker Wants to Curb," Bloomberg, October 31, 2011.)

    Six Ways It Affects You

    The Volcker Rule impacts you in the following six ways:

    1. Your deposits are safer, even though they are protected (up to $250,000 per bank) by the FDIC. But, the Federal government doesn't have enough funds to insure all the bank deposits in America if banks gambled away everyone's deposits.
    2. It's less likely that banks will become too big to fail and require another $700 billion bailout.
    3. Big banks will no longer have the unfair advantage of being able to use 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, yet. (Source: “35 bankers were sent to prison for financial crisis crimes,” CNN Money, April 28, 2016.)

    Who Is Volcker, and Why Did He Get a Rule Named After Him?

    The Volcker Rule was proposed by former Federal Reserve Chairman Paul Volcker while he was the chair of President Barack Obama's 2009-11 economic advisory panel. Volcker was the only Fed Chairman courageous enough to raise the Fed funds rate to uncomfortable levels to starve double-digit inflation. Although this helped cause the 1980-1981 recession, it was successful.