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What Is Volcker Rule?
Volcker rule is a federal prohibition on banks and other financial institutions restricting them from investing in specific categories from their deposit accounts. The whole purpose of Volcker rule covered funds is to stop banks from increasing their investment risks while seeking to maximize their profits from different financial instruments and products.
It is a prominent US federal law from the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. It also limits them from sponsoring a hedge fund and indulging in proprietary trading activities and private equity funds, commonly known as covered funds. Moreover, several regulatory agencies, including the Federal Reserve, the Securities and Exchange Commission (SEC), and the Community Futures Trading Commission, enforce this rule.
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- The Volcker rule is a US federal law. It prohibits banks and other financial institutions from investing or participating in different types of derivatives, options, trading, equity funds, etc.
- It strictly bans proprietary trading for banks and other financial institutions. Thereby, barring them from taking advantage of deposited funds and operating at risk.
- The rule was named after Paul Volcker, an American economist who held the chair of the Federal Reserve.
- Lately, there have been speculations about loosening the terms of the rules to let banks make significant investments in several funds, derivatives, and financial products.
Volcker Rule Explained
The Volcker rule is part of section 619 of the Dodd-Frank Wall Street Reform Act of 2010, which bars banks from using customer-deposited funds to invest in securities and other financial instruments to earn profit. However, per the rules reporting requirements, the bank CEOs must annually attest in writing, ensuring that the bank follows the rule.
Although certain exemptions allow banks to involve in trading, majorly in two circumstances
- Banks can trade when it is quintessential for business-like market making, hedging, trading with limited risk or for underwriting, and reducing interest rate risk.
- Or secondly, the banks can act as their customers' custodians or brokers working on behalf of their customers with legit approval.
Therefore, the Volcker rule exemption allows banks to continue engaging in activities essential to their business operations while limiting their exposure to risky activities.
Thus, the Volcker rule compliance and the Dodd-Frank Act are not broadly popular in finance. Many investors also dislike provisions of the act that require higher investment margins and restrict how investors can trade.
Moreover, this rule requires banks to establish policies and procedures to ensure compliance with the law and to report periodically to regulate their compliance efforts. Hence, this rule aims to promote stability and accountability in the financial system by limiting banks' exposure to risky activities. Besides, the Volcker rule exemption applies to all banking organizations insured by the Federal Deposit Insurance Corporation (FDIC) and other types of financial institutions.
History of Volcker Rule
The Volcker Rule is named after Paul Volcker. He was an ex-Federal Reserve chairman and headed the Economic Recovery Advisory Body in 2009. Hence, he was the one who proposed to monitor and regulate the US banking system and its various trading operations, which are not for the benefit of regular consumers. As an ace economist, Paul Volcker believed and debated that behind the 2008 financial crisis were the US’s significant investment and traditional banks.
Moreover, the Volcker rule summary showed how the US banks engaged in proprietary trading and registered heavy losses. The proposal was backed by Barack Obama and was aligned with the 2010 Congress proposal suggesting a complete financial industry change. Hence, Paul Volcker, the man behind the process, wanted to distinguish between the traditional and investment banking aspects. He was adamant that 2008 when the government had to intervene in the banking system and support them using taxpayer funds, should never come back.
Thus, the Volcker rule meaning and induction goes back to July 2010, when it became a division of the Dodd-Frank Act approved by Congress in July 2010. The Act was delayed in 2010 and was postponed again in early 2013. Finally, On December 10, 2013, the commission defined the and, in January 2014, declared them ordering the banks to get prepared within a time of a year. At last, the Volcker Rule came into action on July 21, 2015, by the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, the Office of Comptroller of Currency, and the Federal Reserve passed the Dodd-Frank Act in December 2014.
Importance
The importance of the Volcker rule is -
- It monitors the US banking system and its trading activities.
- Set rules and regulations for financial institutions regarding investment prohibitions.
- The Volcker rule is in the interest of mitigating risk and using national funds.
- It protects the funds of bank customers from speculative investments, the exact reason for the 2008 financial crisis.
- These rules set a guiding principle for banks and financial institutions regarding different Volcker rule financial instruments.
- Over time, it has been improved, loosening the guidelines and letting banks be involved in investment activities only if they meet specific criteria.
Implications
This rule has several implications for financial institutions, the broader financial system, and the economy as a whole. Here are some of the critical consequences of the rule.
- The Volcker rule checks the US banking system and works as a supervising guideline.
- It may reduce risk management efficiency and force banks to operate in a certain way within the protocols.
- The rule takes away the opportunity to profit or earn good returns from the banks by barring them from investing.
- Volcker rules apply to constrain the bank's funds and how they can use them.
- It will safeguard the regular consumers' funds accumulated in the bank through deposits.
- Hence, this rule requires banks to provide greater transparency into their trading activities and investments in hedge funds and private equity.
Frequently Asked Questions (FAQs)
The main criticisms of the Volcker Rule are -
- In 2017, the US Chamber of Commerce claimed that this rule does not justify its benefits.
- Similarly, International Monetary Fund (IMF) analysts feared enforcing Volcker rule regulations was hard.
- The Federal Finance and Economics Discussion Series (FEDS) complained that it would diminish liquidity due to fewer market creation activities.
Proprietary trading signifies the act of a member trading in securities and other assets on behalf of its firm using money from its account. Per Volcker's rule, proprietary trading is prohibited, so banks cannot use their funds to trade in stock exchanges and other capital markets.
It is worth noting that particular funds may be excluded from this rule. Hence, banks must still comply with other regulatory requirements for these funds. Therefore, here are some of the funds that are excluded from this rule,
- Registered investment companies
- Foreign Public Funds
- Loan securitizations
- Small Business Investment Companies
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