Volcker Rule Summary

How 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 using your deposits to trade for their profit. It forbids them from owning, investing in, or sponsoring hedge funds, private equity funds, or any proprietary trading operations for their use. It prevents them from using funds guaranteed by the Federal Deposit Insurance Corporation  for these hedge funds and private equity funds.

The Rule limits the liabilities that the largest banks can hold.

This limitation reforms former investment banks, like Goldman Sachs and Morgan Stanley. These banks changed into commercial banks during the financial crisis so that they could take advantage of taxpayer-funded bailouts. It 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. That means they are 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 January 19, 2017, Steve Mnuchin testified he supported the Volcker Rule. But he is concerned about how much it limits banks' liquidity. He is President Donald Trump's pick for U.S. Treasury Secretary. (Source: Congressional Hearings for Treasury Secretary, January 19, 2017.)

On July 21, 2015, banks were required to comply with the Volcker Rule.

They've had a year (since April 2014) to put their compliance mechanisms into place. That 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.)

Congress proposed the Rule in 2010 as part of the Dodd-Frank Wall Street Reform Act. It was initially supposed to take effect in July 2012, after two years of review by Federal agencies, banks, and the public. It's the only piece of the Act 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 will implement it. These include the Securities and Exchange Commission (SEC), the Federal Reserve, the Commodities Futures Trading Commission (CFTC), the Federal Deposit and Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency, a division of the Treasury Department.

The SEC and the CFTC said the Rule didn't go far enough in limiting banks' risk-taking. As a result, former Treasury Secretary Jack Lew announced it would require bank CEOs to guarantee personally that their companies are in compliance.

That means they are legally liable for failure to comply. That will probably mean everyone in a bank's chain of command will have to attest personally, as well.  

Also, the Rule prohibits banks from "portfolio hedging." That means they won't be able to trade to offset risks in an asset class. (Source: "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 means that the failure of the bank would devastate the economy, requiring that it must be bailed out with taxpayer funds.

It 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, were small, and not 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. But 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 competitive internationally. 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.

Furthermore, they could do so knowing that the Federal government protected commercial banks in a way investment banks were not. The FDIC protected commercial bank deposits. Banks could borrow money at a cheaper rate than anyone else. That's called the LIBOR rate, and it is just a hair above the Fed funds rate.

These advantages gave the banks with an investment banking arm an unfair competitive advantage over boring community banks and credit unions. As a result, these 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 in two ways. First, as depositors, and then as a source of bailout funds. That's called a moral hazard. It means that bank stockholders and managers won if things went well, but taxpayers lost if things didn't.

Impact of the Volcker Rule

Banks will probably 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 the bank 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 a good thing because these investments made Goldman report its 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.)

How It Affects You

The impact of the Volcker Rule will be felt immediately in the following ways:

  1. Your deposits are safer, even though they are protected (up to $250,000 per bank) by the FDIC. However, 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 over small banks of being able to use hedge funds to improve their profit.
  4. Your local community bank now has a better chance to succeed, instead of being bought out by a big bank. That means more funds for small businesses since community banks are more likely than big banks to lend to them.
  5. It's less likely that you'll wake up one morning and find that a company like Lehman Brothers has failed.
  6. You will see bank CEOs go before a judge, and possibly wind up in jail if they engage in non-compliant trades.

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 economic advisory panel from 2009-2011. Volcker is the only Fed Chairman courageously aggressive 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. Volcker's credibility was needed to overcome intense opposition by the banking industry.