When the Dodd-Frank Wall Street Reform and Consumer Protection Act was introduced as a law in July 2010 under the Obama administration, it had many admirers. However by 2015, many economists, politicians and regulatory authorities seemed to have lost their patience and confidence in the efficacy of the law. The 2,300 page Act with 16 provisions and 400 new rules, Dodd-Frank looked both extensive and complicated. The Act addressed the 2008 financial issues like risky trading, the problem of ‘too big to fail’ (TBTF) and lack of accountability in the financial system. One of the major components of Dodd-Frank is under section 619 known as the Volcker Rule, which restricts
“‘banking entities’ from betting in speculative activities from their own accounts through ‘proprietary trading.'”
After years of delays and modifications, the Rule initiated by Paul Volcker, is finally and largely in full effect. But it faces some serious complications in its interpretation, exemption and implementation. It has been criticised for being layered with lengthy, vague and difficult terminologies, making its enforcement rather difficult.
One of the constant criticisms of the Volcker Rule revolves around its length and ambiguity. In 2010, when the Volcker Rule went to Congress, it took only 10 pages of the Dodd-Frank Act. It now runs in 892 pages of lengthy explanations and is considered one of the most complicated rulebooks in history. The original Volcker Rule has lost its importance and essence over a period of time. Not only that, even the money that has gone in trying to curb its original intentions, runs in millions of dollars. In 2010, when asked about the length of Volcker Rule, Paul Volcker had said,
“I don’t like it, but there it is. I’d write a much simpler bill”
He had further added that he would have loved to see a four-page rule that banned the proprietary rule. But the truth remains that the Volcker Rule promises too much and delivers too little with a significant amount of cost. Clearly, if a rule is difficult to understand, it is difficult to implement. The fuzzy exceptions to the Volcker Rule add to the existing complication.
The additional complication of the Volcker Rule lies in its incoherent limitations and unclear definitions. While the Volcker rule may seem a perfect response to the financial crisis, it nullifies all it’s hard work of well-thought rules with its ‘exemptions’ section. Paul Volcker had said that the banks had pushed for such exemptions and hence the rule has become complicated from its simple original version.
Proprietary Trading from Market Making and Hedging: The Volcker Rule prohibits banking entities from engaging in proprietary trading or retaining “ownership interests” in (or acting as sponsors of) certain “covered funds.” According to the rule, the allowable activities are those related to market-making, hedging and underwriting. Market-making activities allows liquidity and stability in the financial markets. A market-maker facilitates trade by offering prices to the buyer and seller they are willing to pay. Proprietary trading, on the other hand, occurs when stocks, bonds, currencies or derivatives are traded using one’s own account. In addition to the nine exceptions to the ban on proprietary trading, the distinction between these two kinds of activities i.e. proprietary and market-making is blurred due to the indistinct definitions. The unclear difference in the activities can lead to the proprietary trading being disguised or embedded in permissible activities of market-making. Under the rule, market-making remains an allowable activity, but it is a capital-intensive form of liquidity provision leading to a higher cost to the regulatory bodies.
Other than the market-making activities, the Volcker Rule allows underwriting and risk-mitigating hedging activities, but the rule limits these on the basis of positions, inventory and risk exposure. The banks are allowed to engage in hedging activities, but only for “specific” and “identifiable” risks. The Volcker Rule has been filled with jargon that highlight the importance of exemptions in the text. The numerous requirements and exceptions clearly cater to the interests of the banking lobbyists, who have not only delayed the process of implementation but also made it more complex. The banks are required to make this fine distinction between core banking functions and proprietary trading every single day and that could well be a daunting and a costly task to many.
Exclusion of Housing Agency Giants: One fuzzy exception to the rule is permitting trading in bank owned US Treasury bills/bonds or securities issued by Fannie Mae and Freddie Mac. The housing businesses, Fannie Mae and Freddie Mac played a huge role in the financial crisis since they made up the majority of all the ‘proprietary trading’ before the crisis. In 2008, these housing agencies backed roughly 76 percent of housing mortgages and remain the unfinished business in financial regulation. The Volcker Rule has missed some key points to reform the housing finance since the housing giants continue to operate as before posing huge risk to taxpayers.
Delayed Implementation: The delayed implementation of the Volcker Rule has remained one of its biggest hindrances. The rule was scheduled for implementation in July 2010 and the banks have been given time till 2019 to comply with a part of the Volcker rule’s regulation on collateralised loan obligations. Critics have argued that the delay was completely unnecessary since the initial deadline had been 2017. Banks use government-insured deposits for hedge fund trading and as per Volcker Rule, their ownership will be limited to 3 percent in a hedge fund. But the date for the rule’s implementation, too, has been pushed to 2022.
Compliance and Supervision: Daily compliance to the Volcker Rule should hold top priority for the banks and strict implementation of the rule should come first to the regulatory agencies. But, the rule faces strong criticisms that raises concerns on its interpretation and subsequent delayed implementation by the regulators. Implementation of the Volcker rule falls under five agencies with Officer of Comptroller of the Currency, Securities and Exchange Commission, Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation and the Federal Reserve, which could subject banks to be regulated by at least three agencies. It is argued that with lack of clear distinctive activities, there is a high probability of inconsistency and lack of coordination that could result in conflict of interests amongst these agencies. The five agencies can target the same problem in the same bank with a different approach. Not only monitoring agencies, but also banks need to ensure that they have a well-thought enforcement plan that adheres to the Volcker Rule and does not interfere in the daily workings of the bank. Banks are required to maintain manuals that regularly monitor the type of trading and hedging policies used during any simple transaction to make sure they are following the rule. For this, banks might need to hire additional staff that has a clear understanding of the Volcker Rule, moreover who can read the fine print of the rulebook.
The rule, which was supposed to be in effect in 2012, has been subjected to many unnecessary delays due to loopholes pointed out by the Wall Street lobbyists, making it practically insignificant in 2015. While the rule might hold some relevant regulations to adequately address the issues of the 2008 financial crisis, it may not deliver as planned. Strict regulations like the Volcker Rule are not only impractical but also expensive to enforce, especially if they intend to make a difference over a period of time. Persistent supervision by both the regulatory authorities and the banks is a challenging task, especially if it is for a long term. At some point big banks and large financial firms will find ways to mend the rules to make them work in their favor. With such complicated rules, US banks might look for regulatory arbitrage outside its domestic boundaries.
Volcker Rule is a temporary solution to a permanent problem of ‘too big to fail’. If Volcker Rule really aims to address the issues of 2008 financial crisis, it should eliminate the issue of ‘too big to fail’ because as long as large firms exist, they will continue to attract federal support during any future crisis, despite all the adherence to the strict rules in the Dodd-Frank rulebook.