Volcker Rule: Definition, Purpose, How It Works, and Criticism

What Is the Volcker Rule?

The Volcker Rule is a federal regulation that generally prohibits banks from conducting certain investment activities with their own accounts and limits their dealings with hedge funds and private equity funds, also called covered funds.

Key Takeaways

The Volcker Rule prohibits banks from using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures, as well as options on any of these instruments.
On June 25, 2020, Federal Deposit Insurance Corp. (FDIC) officials said the agency will loosen the restrictions of the Volcker Rule, allowing banks to more easily make large investments into venture capital and similar funds.
The main criticism of the Volcker Rule is that it will reduce liquidity due to a reduction in banks’ market-making activities.

Understanding the Volcker Rule

The Volcker Rule aims to protect bank customers by preventing banks from making certain types of speculative investments that contributed to the 2007–2008 financial crisis. Essentially, it prohibits banks from using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures, as well as options on any of these instruments.

In August 2019, the U.S. Office of the Comptroller of the Currency (OCC) voted to amend the Volcker Rule in an attempt to clarify what securities trading was and was not allowed by banks. On June 25, 2020, Federal Deposit Insurance Corp. (FDIC) officials said the agency will loosen the restrictions of the Volcker Rule, allowing banks to more easily make large investments into venture capital and similar funds.

The Volcker Rule aims to protect bank customers by preventing banks from making certain types of speculative investments that contributed to the 2007–2008 financial crisis.

In addition, banks will not have to set aside as much cash for derivatives trades among different units of the same firm. That requirement had been put in place in the original rule to ensure that banks wouldn’t get wiped out if speculative derivative bets went wrong. Loosening those requirements could free up billions of dollars in capital for the industry.

The Volcker Rule is named after economist and former Federal Reserve (Fed) Chair Paul Volcker, who died on Dec. 8, 2019, at age 92. The Volcker Rule refers to section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which sets forth rules for implementing section 13 of the Bank Holding Company Act of 1956.

The Volcker Rule also bars banks, or insured depository institutions, from acquiring or retaining ownership interests in hedge funds or private equity funds, subject to certain exemptions. In other words, the rule aims to discourage banks from taking too much risk by barring them from using their own funds to make these types of investments to increase profits. The Volcker Rule relies on the premise that these speculative trading activities do not benefit banks’ customers.

The rule went into effect on April 1, 2014, with banks’ full compliance required by July 21, 2015—although the Fed has since set procedures for banks to request extended time to transition into full compliance for certain activities and investments. On May 30, 2018, Fed board members, led by Chair Jerome “Jay” Powell, voted unanimously to push forward a proposal to loosen the restrictions around the Volcker Rule and reduce the costs for banks that need to comply with it. The goal, according to Powell, was “...to replace overly complex and inefficient requirements with a more streamlined set of requirements.”

The rule, as it exists, allows banks to continue market making, underwriting, hedging, trading government securities, engaging in insurance company activities, offering hedge funds and private equity funds, and acting as agents, brokers, or custodians. Banks may continue to offer these services to their customers to generate profits. However, banks cannot engage in these activities if doing so would create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within either the bank or the overall U.S. financial system.

Depending on their size, banks must meet varying levels of reporting requirements to disclose details of their covered trading activities to the government. Larger institutions must implement a program to ensure compliance with the new rules, and their programs are subject to independent testing and analysis. Smaller institutions are subject to lesser compliance and reporting requirements.

Additional History of the Volcker Rule

The rule’s origins date back to 2009, when Volcker proposed a piece of regulation in response to the ongoing financial crisis (and after the nation’s largest banks accumulated large losses from their proprietary trading arms) that aimed to prohibit banks from speculating in the markets. Volcker ultimately hoped to reestablish the divide between commercial banking and investment banking—a division that once existed but was legally dissolved by a partial repeal of the Glass-Steagall Act in 1999.

Although not a part of then-President Barack Obama’s original proposal for financial overhaul, the Volcker Rule was endorsed by Obama and added to the proposal by Congress in January 2010.

In December 2013, five federal agencies—the Board of Governors of the Fed; the FDIC; the OCC; the Commodity Futures Trading Commission (CFTC); and the Securities and Exchange Commission (SEC)—approved the final regulations that make up the Volcker Rule.

A bank may be excluded from the Volcker Rule if it does not have more than $10 billion in total consolidated assets and does not have total trading assets and liabilities of 5% or more of total consolidated assets.

Criticism of the Volcker Rule

The Volcker Rule has been widely criticized from various angles. The U.S. Chamber of Commerce claimed in 2017 that a cost-benefit analysis was never done and that the costs associated with the Volcker Rule outweigh its benefits. That same year, the top risk official of the International Monetary Fund (IMF) said that regulations to prevent speculative bets are hard to enforce and that the Volcker Rule could unintentionally diminish liquidity in the bond market.

The Fed’s Finance and Economics Discussion Series (FEDS) made a similar argument, saying that the Volcker Rule will reduce liquidity due to a reduction in banks’ market-making activities. Furthermore, in October 2017, a Reuters report revealed that the European Union (EU) had scrapped a drafted law that many characterized as Europe’s answer to the Volcker Rule, citing no foreseeable agreement in sight. Meanwhile, several reports have cited a lighter-than-expected impact on the revenues of big banks in the years following the rule’s enactment—although ongoing developments in the rule’s implementation could affect future operations.

Future of the Volcker Rule

In February 2017, then-President Donald Trump signed an executive order directing then-Treasury Secretary Steven Mnuchin to review existing financial system regulations. Since the executive order, Treasury officials have released multiple reports proposing changes to Dodd-Frank, including a recommended proposal to allow banks greater exemptions under the Volcker Rule.

In one of the reports, released in June 2017, the Treasury said it recommends significant changes to the Volcker Rule while adding that it does not support its repeal and “supports in principle” the rule’s limitations on proprietary trading. The report notably recommends exempting from the Volcker Rule banks with less than $10 billion in assets. The Treasury also cited regulatory compliance burdens created by the rule and suggested simplifying and refining the definitions of proprietary trading and covered funds on top of softening the regulation to allow banks to more easily hedge their risks.

Since the June 2017 assessment, Bloomberg reported in January 2018 that the OCC has led efforts to revise the Volcker Rule in accordance with some of the Treasury’s recommendations. A time line for any proposed revisions to take effect remains unclear, though it would certainly take months or years. In June 2020, bank regulators loosened one of the Volcker Rule provisions to allow lenders to invest in venture capital funds and other assets.

After the election of President Joseph Biden in 2020, the new administration signaled its support to reverse the Trump era diminutions to the financial system regulations.

What was the goal of the Volcker Rule?

The Volcker Rule’s origins date back to 2009, when economist and former Federal Reserve (Fed) Chair Paul Volcker proposed a piece of regulation in response to the ongoing financial crisis (and after the nation’s largest banks accumulated large losses from their proprietary trading arms). The aim was to protect bank customers by preventing banks from making certain types of speculative investments that contributed to the crisis.

Essentially, it prohibits banks from using their own accounts (customer funds) for short-term proprietary trading of securities, derivatives, and commodity futures, as well as options on any of these instruments. Volcker ultimately hoped to reestablish the divide between commercial banking and investment banking—a division that once existed but was legally dissolved by a partial repeal of the Glass-Steagall Act in 1999.

What are the main criticisms of the Volcker Rule?

The Volcker Rule has been widely criticized from various angles. The U.S. Chamber of Commerce claimed in 2017 that a cost-benefit analysis was never done and that the costs associated with the Volcker Rule outweigh its benefits. The Fed’s Finance and Economics Discussion Series (FEDS) argued that the Volcker Rule will reduce liquidity due to a reduction in banks’ market-making activities. Additionally, International Monetary Fund (IMF) analysts have argued that regulations to prevent speculative bets are hard to enforce.

What was the Glass-Steagall Act?

Spurred by the failure of almost 5,000 banks during the Great Depression, the Glass-Steagall Act was passed by the U.S. Congress as part of the Banking Act of 1933. Sponsored by Sen. Carter Glass, a former Treasury secretary, and Rep. Henry Steagall, chair of the House Banking and Currency Committee, it prohibited commercial banks from participating in the investment banking business and vice versa.

The rationale was the conflict of interest that arose when banks invested in securities with their own assets, which of course were actually their account holders’ assets. Simply put, the bill’s proponents argued that banks had a fiduciary duty to protect these assets and not to engage in excessively speculative activity.

The Bottom Line

The Volcker Rule is intended to restrict high-risk, speculative trading activity by banks, such as proprietary trading or investing in or sponsoring hedge funds or private equity funds. It maintains banks’ abilities to offer important customer-oriented financial services, such as underwriting, market making, and asset management services.

The regulations have been developed by five federal financial regulatory agencies, all described above: the Federal Reserve Board; the CFTC; the FDIC; the OCC; and the SEC.