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Volcker Rule

A federal regulation that prohibits banks from using their depositors’ funds to invest in risky investments

What is the Volcker Rule?

The Volcker Rule refers to Sec 619 of the Dodd-Frank Act, which prohibits banks from engaging in proprietary trading, or from using their depositors’ funds to invest in risky investment instruments. The rule also prohibits banks from owning or investing in hedge funds or private equity funds. 

Before the 2008 financial crisis, banks engaged in speculative trading using their depositors’ accounts, which led to the collapse of several banks and loss of depositor funds. The rule was preceded by the Glass-Steagall Act of 1933, which was introduced during the Great Depression.

 

Volcker Rule

 

Background of the Volcker Rule

The Volcker Rule is named after former Federal Reserve chairman, Paul Volcker, who proposed the rule as a way to curb the US banks’ speculative trading activities that did not benefit consumers. Volcker headed the Economic Recovery Advisory Body under the Obama administration in 2009.

He argued that the banks’ speculative trading activities contributed to the 2008 financial crisis. Large banks that engaged in proprietary trading accumulated huge losses, which forced the government to intervene by bailing them out using taxpayer funds.

The Volcker proposal aimed at separating the commercial banking and investment banking divisions of banks. The divisions were present in the Glass-Steagall Act but the clause was removed in a 1999 repeal. The proposal was endorsed by President Barack Obama, and it was included in the 2010 Congress proposal that recommended an overhaul of the financial industry.

The Volcker Rule is part of the Dodd-Frank Act that was approved by Congress in July 2010. The Act was to be implemented in 2010 but its implementation was delayed until 2013. The final Dodd-Frank Act was approved in December 2014 by the Federal Reserve, Federal Deposit Insurance Corporation, Securities and Exchange Commission, Office of Comptroller of Currency and the Commodity Futures Trading Commission.

The Volcker Rule, and the whole Dodd-Frank Act, are not widely popular in the financial services world, and many investors also dislike provisions of the act that require higher investment margins and restrict how investors can trade.

 

Provisions of the Volcker Role

The Volcker Rule prohibits commercial banks from engaging in the following activities:

 

1. Proprietary trading

The rule prevents banks from using their own accounts to engage in proprietary trading of short-term securities, derivatives, futures, and options. This rule is based on the fact that such high-risk investments do not benefit the bank’s depositors.

 

2. Owning and investing in hedge and private equity funds

The Volcker rule prevents FDIC-insured banks and deposit-taking institutions from acquiring or partnering with hedge funds or private equity funds. Such institutions invest in high-risk investments that banks use to speculate. Using the depositors’ funds to invest in hedge funds subjects the funds to a high probability of incurring losses.

 

Exceptions to the Volcker Role

Even though the Volcker rule prohibited commercial banks from engaging in certain trading activities, the rule allowed banks to engage in the following trading activities:

 

1. Government bonds

United States government bonds are considered low-risk investments that commercial banks can buy and sell since they are backed by the government. Examples of such bonds include Treasury bills, Fannie Mae, and Ginnie Mae.

 

2. Market making and underwriting

Commercial banks are allowed to offer various services such as hedging, market making, underwriting, and insurance services, as well as acting as agents, brokers, or custodians. Offering these services to the banks’ clients can help them generate profits. However, the banks are only allowed to offer the services to their clients and not engage in the activities directly.

 

Related Readings

Thank you for reading CFI’s guide to the Volcker Rule. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your financial knowledge, we highly recommend the additional resources below:

  • Federal Reserve (the Fed)
  • Securities and Exchange Commission (SEC)
  • The Great Depression
  • Top Accounting Scandals

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