More than three years since the Dodd-Frank financial regulation bill got signed into law, a final version of the Volcker Rule emerged raising as many questions as it answers. Named for the former chairman of the Federal Reserve Bank, Paul Volcker, the rule sought to reinstate, at least partially, the prohibition against proprietary trading by banks. During the Depression of the 1930’s, Congress passed the Glass-Steagall Act erecting a wall between investment banking activities and commercial banks which generally hold deposits and provide loans. Over the next several decades, Congress and the Federal Reserve whittled away at that wall culminating in its ultimate repeal by the Gramm-Leach-Billey Act on 1999. That bill effectively allowed large banks to engage in investment banking, insurance, commercial banking and other activities. The subsequent financial meltdown in September 2008 prompted a reappraisal of the wisdom of that repeal. The argument goes that Wall Street banks accumulated excessive risk and engaged in business practices contrary to their clients’ interests which the regulators could not identify.
When Paul Volcker stated his preference for such a rule in January of 2010, he made the case that commercial banks played an integral role in the financial security of Americans and that to allow those banks to also engage in overly speculative investing created too large a risk for the broader economy. He suggested that commercial banks be limited in its ability to owner or sponsor hedge funds, private equity funds, and engage in proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs.
Now, after years of fighting off attempts by Wall Street firms to water down the Volcker rule, the exact text – over 1000 pages of it – of the rule was issued earlier this month. The problem with the rule, however, arises from the difficulty regulators will have in determining what constitutes appropriate investing by banks. Under the rule, banks will still be able to hedge risks – make bets contrary to other positions being taken by these institutions – and to engage in what is known as “market-making”. The practice of market making involves banks making investments in such an industry whereby its customers can adequately generate profits in the same area. How much “market-making” banks will be permitted by regulators constitutes an open question which will challenge the law’s effectiveness.
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