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The Volcker Rule is a section (Title VI) of the Dodd-Frank Wall Street Reform and Consumer Protection Act that was signed into law on July 21, 2010. The rule, originally proposed by former Federal Reserve chairman Paul Volcker, prohibits banks and their affiliates from engaging in proprietary trading, that is, trading for a bank’s own account rather than for its client, and limits banks’ investments in hedge funds and private equity funds. The rationale behind the rule is that banks shouldn’t be allowed to use federally-insured deposit funds to make risky bets.

Some Background

In the aftermath of the 2008 financial crisis, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, of which the Volcker Rule is perhaps the most controversial part. The proposal, now law, has received a flood of criticism, mostly from the banking sector.

The Volcker Rule is complicated, has some exceptions, and isn’t cast in stone yet. The rule prohibits banks from engaging in proprietary trading, but permits hedging to lower a bank’s risk, although determining the difference between trading activities that are allowed and those that are prohibited is sometimes difficult.

The Volcker rule won’t apply to nonbank financial companies, and will apply more loosely to foreign banks than domestic institutions, depending on whether a transaction involves a U.S. citizen or if the foreign bank maintains operations in the United States. Trading in U.S. government securities is exempt from the rule.

Since the 11-page rule was released as part of Dodd-Frank, the proposal has been expanded into a 298-page notice of proposed rulemaking that was submitted for public comment in October of 2011. Bank regulatory agencies are currently busy sifting through the comments and planning how the Volcker Rule will be implemented, which will determine whether the rule accomplishes its goal of limiting banks’ risky trading activities.

Bank regulatory agencies don’t expect to be finished by July 21, 2012, when the rule is scheduled to take effect, whether or not the implementation plans are all in place. Given this uncertainty, some large banks have already begun to trim their proprietary trading operations.

Opposition Aruguments 

Many in the bank industry have expressed their opposition to the Volcker Rule, and we include a few of these arguments here.

For one, Dodd-Frank, of which the Volcker Rule is a part, was intended to remedy the shortfalls of the financial system in order to avoid repeating the mistakes that led to the 2008 financial crisis. However, many contend that problems with subprime and other low-quality mortgage securities, rather than proprietary trading, were largely responsible for the 2008 financial meltdown. Nonetheless, others believe that trading played a role in the crisis and warn that proprietary trades that go bad could cause big problems for the banking industry in the future.

Another argument against the rule is that forbidding banks to engage in proprietary trading might result in less liquid bond markets. A number of foreign banking authorities, including the Bank of Japan and Canadian banking officials, have expressed concern that the Volcker Rule might hurt the trading of their nations’ debt instruments. The European Commission is worried that the Volcker Rule will discourage U.S. banks from trading the bonds of troubled European nations, thereby raising those nations’ borrowing costs and delaying their recoveries. The foreign banks want the exemption for U.S. government securities to be extended to their nations’ debt. Some foreign bankers also appear to resent the rule’s ability to considerably expand U.S. bank regulators’ reach overseas.

On the other hand, some bank regulators don’t believe bond-market liquidity will be a problem. They expect hedge funds to step into the space abandoned by banks, and some trading activity to move overseas, where no rule similar to Volcker has been adopted. Still, those against the rule counter that U.S.-based banks will lose clout in global banking markets, and that they will need to offset the income lost from exiting proprietary trading by jacking up the fees they charge businesses and consumers stateside.

In Sum

In the end, regulators will need to finalize rules that the banking industry can live with, while limiting risky trading activities. In the process of deciding how to implement the rule, some parts of the Volcker Rule may be changed.

There was some talk in Congress recently of delaying the implementation date, and banks are pressing regulators for more details regarding how the Volcker Rule will be enforced in advance of the July implementation date. The banks fear the rule will go into effect before regulators complete their implementation plans, creating considerable uncertainty in the meantime as to whether the banks should continue to engage in certain trading activities and raising fears that they may run afoul of the final version of the rule.

As it stands now, banks have two years to bring their operations into compliance with the Volcker Rule, but regulators have called for banks to comply with the rule as soon as they can, creating additional confusion.

Until regulators provide more guidance concerning the rule, the bank industry may operate in a kind of gray area.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.