The Volcker Rule: Still Problematic

Douglas J. Elliott

Late yesterday, the administration sent Congress suggested legislative wording to implement the “Volcker Rule” proposal which President Obama had announced in January. As anticipated, the specifics do not eliminate the inherent problems that were apparent in the initial announcement.

The proposal’s limitations on size will do very little in regard to banks that are “too big to fail” and the ban on proprietary investments and trading is rife with problems. The size limitation is likely to be fairly meaningless and therefore may do little harm, except by distorting the market slightly to no purpose. However, the proprietary trading rule is not harmless: it could do significant damage in practice by unreasonably constraining legitimate bank investment decisions, thereby reducing profits and potentially increasing risk. This legislative language is particularly disappointing since prior reform proposals from the administration have generally used a subtle combination of incentives and disincentives to achieve a sound balance between the need for greater safety and the risk of dictating decisions that are better left to the markets.

The “Volcker Rule” should really be expressed in the plural form, because its two aspects are essentially unrelated except in the very general sense that both have the broad intent to reduce the risk of loss to taxpayers from the failure of a very large bank. (This is a noble goal; it is the execution that is problematic.)  The first part is a fairly straightforward extension of an existing size limitation for banks in a way that is intended to better capture the key risk sources. Currently, banks may not make acquisitions that would increase their share of the national deposit market above 10%. The new test would prohibit banks from exceeding the same 10% market share, but with a wider definition of size that takes account of the riskiness of the assets, as well as the total level of liabilities, both from deposits and other funding sources.

It is certainly reasonable to use a wider definition in order to discourage large banks from taking excessive risks. However, this step should not be construed as doing much of anything about the “too big to fail” problem. In the recent financial crisis, the government stepped in to rescue financial institutions that were well below the line drawn by this revised test, and would likely do so in the future. For example, a failing institution with an 8% share of the market would quite likely be large enough to cause systemic problems. In fact, there are only three U.S. banks that appear to exceed the 10% limit now, yet virtually any analyst would agree that there are many more institutions than this that the government would feel compelled to rescue in a severe financial crisis, barring other dramatic reforms.

Nor would the institutions with existing market shares higher than 10% be affected very much, except by being constrained from further acquisitions. In addition, it must be remembered that the deposit market share rule was overridden by government regulators during the crisis whenever a major bank was needed as a buyer of a large troubled institution. It might well be overridden in a future crisis when a forced merger appears better for the financial system than the liquidation of a large bank. In fact, the legislative language allows for such an exception.

The second part of the rule is a ban on “proprietary” trading and investments. Unfortunately, the new language still does not define what “proprietary” means. Any investment owned by a bank for its own account can be considered proprietary, in the larger sense that the bank absorbs any losses and keeps any gains. Therefore, the rule is forced to rely on judgments as to the intent behind the purchase of the asset. Banks will be allowed to own investments that they reasonably believe are needed as inventory to assist in their customer-related trading activities or as part of a hedge of customer-related activity. Further, by implication, it appears that investments that are part of the firm’s overall liquidity management will be exempted, since they are not part of a “trading book.” That term is also essentially defined by intent. The same asset could be held for liquidity management outside of a trading book, yet be bought and sold in exactly the same manner as if it were in a trading book.

Unfortunately, separating out the targeted activities from the permitted ones risks forcing regulators to micro-manage the investment side of banking. Since there is absolutely no clear line between proprietary and other investments owned by banks based on the intrinsic nature of the investment, the rule will rely on the bank’s stated intent behind owning the asset. However, for this to be meaningful, regulators will have to use their discretion to determine if they think certain investments really were bought for the reasons alleged. Bank examiners may well err on the side of caution by effectively deciding certain types of investment are inappropriate for the stated purpose, even though there is unlikely to be much intellectual basis for drawing such a distinction. Unreasonable constraints on bank investments would reduce profitability and potentially even increase risk, both of which would make the system less robust.

Clearly the underlying concern is that banks may take excessive investment risks. There are already substantial mechanisms in place, principally through the capital rules, that try to deter such excess.

It would be much better to refine how those mechanisms work than to switch to a system that relies so heavily on determining the true intent of a banking decision. The large majority of regulators globally are following that more subtle approach, for good reason.

Fortunately, it appears unlikely that the Volcker Rule’s limits on investments will survive into the final larger banking reform legislation except, perhaps, in a form that allows much more regulatory discretion. There has not been a groundswell of Congressional support for these provisions, to say the least. Indeed, there was a fair amount of initial consternation, since the administration had already passed up several earlier opportunities in 2009 to indicate that such limits were important or even desirable.