Volcker Rule: Hero or Villain?

With the Dodd-Frank Act’s Volcker rule coming into effect next month and placing limitations on big banks’ trading abilities, we asked bank attorneys across the country what they thought would really come from this change. Although many different possible scenarios were cited, it was almost unanimous that all the attorneys believe the Volcker rule is likely to cause more damage than good. From hurting the efficiency of our markets to heightening other risks and limiting diversification, one must wonder, is the Volcker rule really going to be a good thing for the health of the financial system? 

Will the Volcker rule achieve its intended goal of lowering the risk profile of large banks by prohibiting them from engaging in proprietary trading activities?

The Volcker rule is unlikely to achieve its intended goal because it is so difficult to distinguish proprietary trading from hedging and market-making. Banks are already limited by the types of instruments and securities they can trade in for their own account by Section 16 of the Glass-Steagall Act, which remains in effect as Section 24(7) of the National Bank Act. The most likely effect is that systemic risk may increase as market liquidity decreases, as banks and their affiliates maintain smaller securities inventories, consistent with the Volcker rule proposals. This could widen securities’ bid/ask price spreads, and make the markets less efficient. This will also have an adverse effect on smaller financial institutions which depend upon larger banks and their trading desks for their investment securities purchases and sales.

—Chip MacDonald, Jones Day

Rules are destined to be broken. Like so many well-intentioned laws and regulations, the Volcker rule might end up doing exactly the opposite of what is intended—that is, increasing the risk profiles of large banks, through hedging and other transactions with higher risks than old-fashioned proprietary trading activities. Can you identify any proprietary trading investments that have caused losses in the same ballpark as JPMorgan’s recently acknowledged losses or the hedge fund Long-Term Capital Management’s losses back in 1998? These losses illustrate that the financial marketplace can be a tough taskmaster when seemingly well-thought-out investment strategies, by some very smart traders, run into the ever-changing real world marketplace. No one has a lock on what will work best in the future financial marketplace, but savvy, conservative bankers with competent advisors usually do all right in the long-run.

—Doug McClintock, Sara Lenet, Alston & Bird

I am generally skeptical of the Volcker rule’s purported benefits to bank safety and soundness. I think appropriate capital, leverage, and liquidity requirements—when combined with a robust risk management framework and culture inside each institution—will do far more to lower the risk profile of large banks. Moreover, the Volcker rule in its current form only compounds the problem by requiring regulators and market participants to make, in some cases, spurious distinctions between and among proprietary trading, market making and hedging. 

—Heath Tarbert, Weil, Gotshal & Manges LLP

Certainly the Volcker rule will restrain bank proprietary activities, and any reduction of activities reduces risk profiles to a degree. However, after a point, protection turns to paralysis. Years after Dodd-Frank, there still has been no evidence that proprietary trading contributed to the financial crisis, and the rules could put U.S. banks at a competitive disadvantage, particularly with respect to their worldwide operations.

 —Greg Lyons, Debevoise & Plimpton

It is too early to determine the ultimate scope of the Volcker rule.  Regardless of the ultimate shape of the Volcker rule, the real key is whether financial institutions can set appropriate risk tolerances, monitor adherence and stay within them. The leaders of the bank regulatory agencies recently were questioned by the Senate Banking Committee in the aftermath of the JPMorgan Chase & Co. $2 billion-plus trading losses. The regulators were unanimous that risk neither should be nor could be removed from banking. The focus on hyper- technical rules, such as those promulgated in draft form to enforce the Volcker rule, rather than on risk management principles and practices, is misplaced.

—Peter Weinstock, Hunton & Williams

By completely taking away proprietary trading and investment in and sponsorship of private equity, hedge and other similar private funds, the Volcker rule inappropriately concentrates investment and other risk in other activities and asset classes, all of which have run into calamities in the past. For example, subprime lending is not barred by the Volcker rule. We will not be well-served in the long run by having the largest and most sophisticated U.S. financial institutions become one or two-trick ponies. That said, the Volcker rule is upon us and, in the absence of final regulations, we are spending lots of time with clients developing conformance plans with our divining rods.

—Mark Nuccio, Ropes & Gray