July 9, 2018

Financial Reform: Overview of the Volcker Rule

Background substantial federal government financial assistance to the
Legislators and regulators have long grappled with whether financial sector, which proved politically unpopular. These
restricting the types of activities banks can engage in, or interventions raised concern about taxpayers’ exposure to
reforming banks’ structures, might reduce the risk of large financial crises. The fact that banks were protected from
bank failures and the risk of systemic financial instability, potential losses by taxpayer-backed deposit insurance and
such as that seen in the 2008 financial crisis. The Volcker other federal assistance, such as short-term lending by the
Rule is an example of a means of addressing this issue. central bank, further aggravated concerns. The Volcker
Rule’s prohibition of proprietary trading attempts to prevent
The statutory basis of the Volcker Rule is Section 619 of bank holding companies whose depository banks have
the Dodd-Frank Act, enacted in 2010 following the crisis. It
access to such government safety nets from speculating in
was conceived of by Paul Volcker, a former Federal
financial markets.
Reserve (Fed) chair, and implemented as “the Volcker
Rule” in a 2013 joint final rule by five financial regulators:
the Fed, Federal Deposit Insurance Corporation (FDIC),
Issues in Volcker Rule Implementation
The Volcker Rule exempts certain securities, such as
Office of the Comptroller of the Currency (OCC), Treasuries, from the ban on proprietary trading. It also
Securities and Exchange Commission (SEC), and
exempts certain activities such as hedging and market
Commodity Futures Trading Commission (CFTC).
marking. A fundamental challenge in implementing the
The Volcker Rule generally prohibits a depository bank (or Volcker Rule has been devising a clear way to distinguish
company that owns one) from engaging in proprietary between trading by banks for speculative purposes and
trading or investing in (or sponsoring) a hedge fund or other allowable purposes. From the outset, regulators and
private equity fund. The rule has been subject to debate and academics acknowledged that it is difficult to discern
was recently amended through legislative action. whether a financial trade is aimed at profiting from market
Regulators have also proposed further changes to the rule. movements or hedging existing assets against market
movements. Market-making entails buying and selling
Prior to the Dodd-Frank Act, no statutory definition of instruments, such as stocks or bonds, for the purpose of
proprietary trading existed, but the concept was generally fostering a liquid market in them, often for the benefit of a
understood to mean trading by an entity for its own profit client, such as a company issuing shares. It can be hard to
and loss, rather than on behalf of a client for commission- distinguish whether a firm is holding such securities in
or fee-based income. Section 619 defined the term, in part, order to foster a liquid market or to profit from them.
as “engaging as a principal for the trading account of the
banking entity or nonbank financial company…in any To implement Section 619 of the Dodd-Frank Act,
transaction to purchase or sell, or otherwise acquire or regulators were challenged with creating standards to
dispose of” financial instruments, such as securities and distinguish between these activities. This inherent challenge
derivatives. may have contributed to the final rule’s length and
accusations that it is overly complex and cumbersome to
A well-known prior example of a restriction on banks is the follow and for bank supervisors to use. The Volcker Rule
Glass-Steagall Act, passed in 1933 during the Great has not only faced criticisms from opponents that it is too
Depression. Glass-Steagall generally prohibited certain strict, lengthy, and burdensome, but also from proponents
deposit-taking banks from engaging in various securities of financial reform and consumer advocates that it does not
markets activities associated with investment banks, such as go far enough to prevent banks from proprietary trading.
speculative investment in equity securities. Glass-Steagall Some questioned why the 2013 rule presumed short-term
also prohibited banks from affiliating with securities firms. trades of less than 60 days to be proprietary unless
Over time, regulators became more permissive in their otherwise proven, whereas longer-term trades were not
interpretations of Glass-Steagall, allowing banks to subject to such a presumption.
participate in more securities market activities, directly or
through affiliations. In 1999, the Gramm-Leach-Bliley Act In an April 2017 speech, former Fed Governor Daniel
repealed two provisions of Glass-Steagall, which further Tarullo, who helped implement the rule, flagged several
expanded permissible activities for certain banks and problems with it in practice. He noted that, although the
permitted banks to affiliate with securities firms. purpose is worthy, the involvement of five different
agencies made it complex to supervise and follow. He also
The 2008 financial crisis rekindled the debate over what noted that the ongoing need for data-driven, contextual
activities banks should be allowed to engage in. In the run- guidance from the different regulators took up excessive
up to the crisis, banks took on excessive risks, including regulatory and bank supervisors’ time and led to increased
through proprietary trading in complex derivatives, compliance costs for banks. He stated that the rule might
mortgage-backed securities, and other financial contribute to reduced market-making liquidity in some
instruments. Excessive risks led to losses that precipitated

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 Financial Reform: Overview of the Volcker Rule

financial instruments and is unnecessarily costly for small- requirements. An additional 22 banking organizations fall
and medium-sized banks with few trading activities. into this category. Firms with “limited trading
activity”―those with less than $1 billion of trading assets
Legislative Changes and liabilities―would be presumed compliant. The Fed
On May 24, 2018, President Trump signed into law P.L. estimated that the 40 banking organizations with significant
115-174, which made a variety of changes to financial or moderate trading activities account for 98% of total U.S.
regulation and to the Volcker Rule. First, the new law trading activity by banking entities.
exempted any bank holding company with less than $10
billion in consolidated assets from having to comply with In addition, the proposal modifies what constitutes
“proprietary trading” by eliminating the “rebuttable
the Volcker Rule if the firm’s total trading assets or
presumption” in the Volcker Rule that trades held for less
liabilities also do not exceed 5% of total consolidated
assets. than 60 days be presumed part of a proprietary trading
account unless the bank shows the intent of the trade was
Second, the law relaxes somewhat the prohibition on bank not for short-term trading gains. Banks complained this
entities “sponsoring” hedge funds or private equity funds by requirement was too ambiguous and time-consuming. The
sharing the bank’s name, or variant of it, with the fund – a proposal eliminates this rebuttable presumption for short-
practice usually used for marketing or promotional term trades.
purposes. The ban’s initial logic was to prevent banks from
creating the impression, or the reality, that they would Analysis of Changes
“backstop” such funds in bad times, which could potentially Although the original Volcker Rule included tailoring for
create bank losses, and ultimately, the FDIC and taxpayer small banks, a broader exemption for smaller banks such as
losses, if such losses proved severe. Banking associations, in the law and in the agencies’ proposal had been
however, argued that this restriction hindered banks’ role in anticipated for some time. Some observers were critical of
capital formation and put them at a competitive asset-size thresholds as a regulatory standard for the
disadvantage relative to nonbanks when it came to Volcker Rule, arguing it should be tailored based on the
sponsoring such investment funds. The question of whether riskiness of the business model instead.
this disadvantage was intentional and desired, or unfair and
undesirable, depends on one’s viewpoint. The new law Neither the new law nor the agencies’ proposal makes
substantial changes to the restriction on banking entities
permits banks to share their names with such funds under
investing in private equity or hedge funds, despite the
several circumstances. Regulators announced they will
incorporate these legislative changes into a future modification of the naming prohibition on such funds. The
proposal potentially relaxes certain requirements for banks’
rulemaking.
ownership interests in covered funds when they relate to the
banks’ market making or underwriting activities.
Agencies’ Proposal for Reform
On May 30, 2018, the Fed released a new proposed rule Changes to the Volcker Rule in the agencies’ proposal and
that would revise the Volcker Rule. The proposal does not in P.L. 115-174 garnered significant, and divergent,
address how to implement P.L. 115-174, which is to occur attention in the press and in Congress. Some Members of
in a separate rulemaking. The Fed stated in its Board memo Congress, including the ranking members on the Senate
that “staff has identified opportunities, consistent with the Banking and House Financial Services Committees, argued
statute…to incorporate additional tailoring…based on the that these changes would make it easier for banks to engage
activities and risks of banking entities and to provide in speculative trading, amplifying risks at these banks. In
greater clarity about the activities that are prohibited and contrast, proponents of these changes, including the Senate
permitted.” The Fed said the proposal would make it easier Banking Committee and House Financial Services chairs,
for bank supervisors to assess compliance with the Volcker said they would streamline regulation and improve clarity
Rule. The FDIC, OCC, SEC and CFTC, which had jointly and efficiency.
with the Fed issued the original Volcker Rule in 2013, each
voted to support the proposal, with dissents at the SEC and Outside of Congress, assessments of the modifications also
CFTC. diverged. The financial industry welcomed the changes,
saying it would reduce compliance burdens and increase
A key change is that the new proposal categorizes firms regularity clarity. However, certain regulatory leaders
based on their trading activities’ size and envisions that opposed the changes. Two SEC commissioners and one
only those with the largest trading books will be subject to CFTC commissioner voted against the proposal. In dissents,
the most scrutiny. The Fed said this approach would more they stated that expanding what qualified as risk-mitigating
accurately tailor the regulation to the trading risk profile of hedging (as opposed to proprietary trading) could
a firm rather than to its size by total assets. Firms that have potentially enable evasion of the rule. They voiced concern
worldwide trading assets and liabilities―including those of that relaxing the proprietary trading prohibition without
their affiliates―which exceed $10 billion when added over finalizing rules restricting compensation for excessive risk
the four previous quarters are considered “significant” taking at banks would likely encourage such risk-taking.
trading exposures. The Fed estimated this would cover 18
banking organizations. Rena S. Miller, rsmiller@crs.loc.gov, 7-0826
Firms with more than $1 billion but less than $10 billion in IF10923
trading assets are to be deemed to have “moderate” trading
activities and are to face significantly reduced compliance

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