Financial Regulation

No, Repealing the Volcker Rule Won't Cause an Economic Collapse

Instead of limiting what risks banks can take, the government should force banks to live with the consequences of those risks.


Mike Roy/TNS/Newscom

The Federal Reserve on Wednesday announced a series of changes to Obama-era banking regulations intended to prevent banks from taking unnecessary risks with their clients' money. The move will free smaller financial institutions from onerous federal rules and allow regulators to focus their attention on bigger banks that take greater risks.

The changes to the so-called Volcker Rule—named for former Federal Reserve Chairman Paul Volcker, who suggested the basic premise behind what eventually become a 700-plus page regulation included as part of the Dodd-Frank Act—were quickly criticized for supposedly bringing the entire financial system back to the precipice of 2008.

"This proposal is no minor set of technical tweaks to the Volcker Rule, but an attempt to unravel fundamental elements of the response to the 2008 financial crisis, when banks financed their gambling with taxpayer-insured deposits," Marcus Stanley, policy director at Americans for Financial Reform, told The New York Times. "If implemented, these proposals could turn the Volcker Rule into a dead letter, a regulation that would not meaningfully restrict trading activities at the banks whose problems could drag down the entire financial system—again."

The reality is quite different. For starters, that's because the Volcker Rule isn't actually being repealed.

In theory, the Volcker rule is supposed to stop banks from engaging in what's known as "proprietary trading"—using money on the bank's own balance sheet to engage in speculative trades intended to generate profit for the bank. Typically, financial institutions make money by charging a fee for transactions on behalf of their clients, but proprietary trading allows banks to make direct bets on the market in the same way that individual investors might.

Complicating matters is that fact that banks routinely do invest some of their holdings as a way of protecting against risk in other parts of their portfolios. This hedging is a sound, and important, banking practice. But how do you tell the difference between hedging and risking proprietary trading? As Reason's Peter Suderman noted in 2012, that question hamstrung much of the debate over the Volcker Rule and the Dodd-Frank Act in general. In the end, the law evolved as the legislation was written and ended up leaving banks with significant leeway to hedge various risks.

But like so much in Dodd-Frank, the Volcker Rule has never been very clear about the distinction between hedging and taking unnecessary risks. No one less significant than the "Frank" in Dodd-Frank slammed the final version of the Volcker Rule when it went into effect for creating an "untenable" situation where banks were being forced to comply with a rule that failed to articulate how to comply with it.

"The results reflected in the proposed rule are far too complex, and the final rules should be simplified significantly," then-Rep. Barney Frank (D-Mass.) told The Hill in July 2012.

That's exactly what's finally happening.

"This proposed rule will tailor the Volcker rule's requirements by focusing the most comprehensive compliance regime on the firms that do the most trading," Fed Chair Jerome Powell said in a statement. "Firms that do more modest amounts of trading will face fewer requirements."

Specifically, the changes divide financial institutions into three tiers. As CNBC explains, banks with more than $10 billion in assets—Wells Fargos and Goldman Sachses of the banking world—will still need to comply with the strictest set of rules, while banks with between $1 billion and $10 billion in assets will face "reduced compliance requirements" and those with less than $1 billion will no longer have to demonstrate compliance with the Volcker Rule at all.

That's in line with a set of Dodd-Frank reforms passed by Congress and signed by President Donald Trump earlier this month. That law will exempt banks with less than $250 billion in assets from Dodd-Frank's so-called "enhanced prudential standards"—strict regulations regarding liquidity, risk management, and capital meant to serve as a "stress test" for banks' balance sheets. Together, the two actions indicate that the Trump administration is taking a pretty reasonable approach to financial regulation: asking bigger banks to shoulder heavier regulations and preventing those rules from swamping smaller financial institutions. Additionally, the changes will allow federal regulators to focus their enforcement efforts on the banks that could prove to be an actual risk to the economy if they overplay their hands.

Of course, it might be preferable to have fewer financial regulations on all banks. Instead of limiting the types of risk that financial institutions can take, government should simply force banks to face the consequences when those risks fail to pay off. But as long as there is an implicit—or explicit—promise that taxpayers will serve as a backstop to banks considered "too big to fail," then it probably makes sense to force the banks representing the biggest potential cost to taxpayers to comply with additional rules.

Addressing that moral hazard is essential to correcting the current shape of financial regulations. In the meantime, setting the little guys free from rules that were only ever meant to be aimed at Wall Street's biggest banks is likely to benefit investors and entrepreneurs by increasing market liquidity and access to credit.

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  1. Instead of limiting what risks banks can take, the government should force banks to live with the consequences of those risks.

    Let’s not get ahead of ourselves. We set rules for our children and then buy them a car when they fuck up.

  2. Dodd Frank was written to codify Too Big To Fail. Nothing in these rule changes have changed that, so fans of Dodd Frank should relax.

    1. Not true. If a huge bank like Well Fargo fails because of bad investments or overextending itself, it will be busted up into several smaller entities. You really should read at least an overview of the law. Still none of the bastards who make choices that lead to that will be punished even in if they are acted on bad faith. There is nothing in the law against golden parachutes.

      1. So it made them all federal employees? I guess I should read the law in its entirety.

  3. “”””Wells Fargos and Goldman Sachses of the banking world?will still need to comply with the strictest set of rules”””

    Which rules, Goldman Sachs was allowed to convert from a Investment Bank to a Commercial Bank in 2008 which then allowed them to get direct loans from the FED. Henry Paulson former Chairman of Goldman and now Secretary of the Treasury signed off on the deal. So Goldman has a history of getting the rules changed when it benifits them

  4. “Instead of limiting what risks banks can take, the government should force banks to live with the consequences of those risks.”

    May well have a salutary effect!

  5. Friend at a big bank spent a lot of time and money to devise ways to meet federal requirements for liquidity.

    Bank looked around and noticed that 1) this was expensive and 2) no one else was doing it. So they said fuck it.

    So, I don’t think repealing regulations that no one is following will make a real difference.

  6. It should be noted that banks have other legitimate reasons to trade on their own accounts–including market making. If Bank XYZ wants to offer its airline clients a derivative against the downside of future oil shocks, and it can’t find enough customers willing to take the other side of that trade at the moment, they might take that risk on themselves with the hope of reselling those obligations at a later date. Such market making activity may be good for the bank, good for the airline, and good for energy companies who buy the other side of those derivatives to protect themselves in the case of oil unexpectedly plummeting.

    That’s just one example. Investment banks are the machinery that makes creative destruction happen, and they should be given free reign to innovate. In short, the idea that politicians or voters are in any way capable of making rules for capitalism, who should and who shouldn’t be free to invest, what they should be free to invest in, etc. is hilariously stupid.

    All of this Obama era regulation was meant to do one thing: assuage blame for bailing out the banks.

  7. Accept the following truths:

    1) There is no amount of regulation that will prevent the next downturn in the economic cycle.

    Economic cycles don’t work that way. You’ll just end up making it harder to claw our way out of the next downturn.

    2) Regulating banks will not prevent politicians from bailing them out.

    The bailout was unnecessary. The bailout and the subsequent regulation was far more harmful to the economy than the failure of Bear Stearns and Lehman Brothers.

    Meanwhile, blaming banks for politicians bailing them out is absurd. If you want to stop politicians from bailing out banks, the solution is at the ballot box.

    God bless the Tea Party circa 2008.

    1. Big win for the Caps.

      BTW, am I the only one who’s bothered that the Golden Knights logo is a Corinthian style helmet from the bronze age?

  8. the Volcker Rule has never been very clear about the distinction between hedging and taking unnecessary risks.

    *** scratches head ***

    Well, I suppose that means the Volcker Rule is taking unnecessary risks.

  9. The thing to keep in mind is that a lot of the Big Crash that inspired the rules now under examination was caused by a Government Big Idea. I didn’t follow it closely, but I remember when talk started about making lemders be ‘more fair’ to minorities who couldn’t qualify for home loans under the old rules. And I remember economists of,several,schools,saying, in effect, “We hope you like bailing out lenders, because you’re going to have to.”

    Naturally, the banks weren’t allowed to have special lending rules for brown people, so the rules got changed for everybody. And from that point, the beginning of the housing bubble, the whole mess was headed for a crash of epic proportions. President Bush II tried at least twice to dig into the mess that Fannie Mae and Freddie Mac were making, and was blocked by the Democrats.

    1. Cntd.

      People have told me that Congress should have held hearings to ‘get to the bottom’ of the mess. Well, unless they were even dumber than I think they were, Congress knew damned well what was at the bottom, amd kmew that if they held hearings somebody was likely to tell them on camera. Thus, no hearings.

      People have also roundly denounced the people who were running the lending institutions and the big banks at the end. Well, that only makes sense; tell a,whole industry to do something catastrophically stupid, amd the smart and ethical people are going to bail. Leavig you with the cowboys, con men, and pond scum.

      1. “…Well, unless they were even dumber than I think they were, Congress knew damned well what was at the bottom, amd kmew that if they held hearings somebody was likely to tell them on camera….”

        Not only was congress dumber than that, but Greenspan whined that he ‘thought the market would fix it!’.
        Well, Alan, you and we now know:
        Q: “How far can you distort the market before you cause a really bad fuck up?”
        A. “Somewhat less than the US gov’t did prior to the 2008 crash.”
        Turd (here) claims it was a ‘free-market failure’, as if banking has been anything like a free market since Hamilton established chartering rules for banks, and it has not gotten ‘free-er’ since.
        By 2008, mortgage lending was an exercise in social engineering, having nothing to do with pricing risk and protecting the vault; Uncle Sugar was gonna save us!


    1. Welch? He doesn’t run the joint anymore. Its KM-W’s domain. Matt is off on the twitters telling everyone how much he wants to blow his NeverTrump man-crush Trey Gowdy.

  11. the government should force banks to live with the consequences of those risks.

    That’s never the way it works and the statement itself almost makes me wonder whether the author was even alive in 2008.

    When banks go under, they threaten the monetary system – NOT just ‘government’. No money = no economy.

    There is no rule that can change the above.

    So the only way that ‘government’ can successfully let the banks fail is to have an alternative competitive monetary system in place before the crisis hits. That means an alternative money that the government itself would switch to for its own payments/settlements – and can be opened up to anyone else too.

    If you don’t have the balls to create the alternative before the crisis, you won’t magically acquire balls during the crisis

  12. I’m surprised at Reason spouting the idea that a “bank” ever faces consequences. A bank is an abstraction. Shareholders and creditors might face consequences, but the bank, the officers and directors who run the bank don’t necessarily face any. If the bank fails, the latter move on to the next opportunity. Free banking may have worked when the bank managers actually owned the banks and were personally responsible for failure, but sadly in this day and age of hired, unaccountable managers, regulation of risk-taking would seem to be needed.

    1. Now explain why an unaccountable federal government is better equipped than those shareholders and creditors to impose such constraints.

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