The so-called Volcker Rule has received a lot of attention lately in the media, largely due to the trading loss incurred by JPMorgan Chase earlier this month. Here are some thoughts on the rule and its role in history.
The Volcker Rule
The Volcker Rule is a term used to describe Section 619 of the Dodd-Frank “Wall Street Reform and Consumer Protection Act” passed in 2010 as part of the financial reform.
The conceptual interpretation of the rule is as follows:
Banks are prohibited from making risky, short-term trading investments, either directly by trading in their own account or indirectly through means of a hedge fund or private equity fund.
In short, banks may not trade their own capital in “risky” investments, since that capital must be preserved to meet requirements of demand deposits.
There are, not surprisingly, various minor exceptions and wrinkles in the details, but this is the core concept behind the Volcker Rule.
To fully understand the purpose and intent of the Volcker Rule, it is worthwhile to review the history of banking regulation.
The Financial Reforms of the 1930s
After the financial collapse in 1929, Congress enacted several laws to reform the financial and banking industry. The most prominent of these was the Banking Act of 1933, called the Glass-Steagall Act.
This act codified the traditional view of the purpose of a commercial bank: it should take short-term deposits from individuals and businesses and make long-term loans based upon those deposits.
The rationale behind this viewpoint was that banking safety would be best ensured by having banks make long-term, secure investments, such as loans. If banks made, by contrast, short-term investments, and suffered losses, they might become unable to redeem the short-term deposits made by customers.
An inability to redeem short-term deposits by customers was the cause of bank failures in the 1930s, as customers rushed to withdraw their savings from banks with insufficient capital to redeem them.
The banking and financial reforms of the 1930s were based upon a simple idea of creating two distinct kinds of banks: commercial banks and investment banks.
The distinction between these two banks was conceptually simple and based upon the contrast between short-term and long-term investment perspectives.
- Commercial banks would have short-term liabilities (such as checking deposits) that were backed by loans with short-term payment schedules (monthly payments) and by hard assets.
- Investment banks would have long-term liabilities, but could also own assets with long-term reward characteristics. However, they would be prevented from taking demand deposits (such as checking accounts), which are short-term liabilities.
Since commercial banks were the only institutions allowed to take demand deposits, they were the primary means of saving for most individuals. This was in the era before mutual funds and self-directed brokerages.
Commercial banks were also prevented from reselling or securitizing the long-term loans they made. Mortgages were originated primarily from banks and banks held the mortgages until the loan was paid.
The central idea was that commercial banks would always be able to meet the needs of demand deposits, since their income stream was both long term and predictable, and backed by the hard assets of a home or business.
Investment banks, on the other hand, were allowed to serve the capital raising needs of businesses (by underwriting public offerings), to invest in businesses directly, or to manage investment accounts for others. All of these functions were forbidden to commercial banks.
Investment banks were allowed to trade in short-term investments, either on their own account or on behalf of clients. They were not allowed to make long-term loans that competed with commercial banks, such as mortgages.
The primary source of income for investment banks was fees and trading profits. The primary source of income for commercial banks was interest paid on loans.
After the Glass-Steagall Act, a bank was either a commercial bank or an investment bank. The types of activities engaged in by each type of bank were mutually exclusive.
A separate type of entity, the registered investment company, was allowed to serve as an investment advisor and account holder for clients. This type of company, the traditional “stock brokerage” firm, could be a standalone company or could be owned by an investment bank.
To enforce the short-term nature of commercial banking activities, the rates paid on deposit accounts was regulated and set by the Federal Reserve. This provision would eventually lead to the undoing of the entire Glass-Steagall Act.
The Erosion of the Glass-Steagall Act
Over time, the restrictions on commercial banks became relaxed.
The beginning of this erosion occurred when interest rates began to rise dramatically in the late 1970s and early 1980s.
The introduction of money-market accounts by investment banks and investment companies in the early 1980s became a prime source of competition for commercial banks.
At a time when banks were limited by law to paying a maximum of 4% on deposits, money-market accounts were offering interest payments in the 10-14% range.
The money-market account was not technically a “checking account,” nor was it a demand deposit. It was instead, legally, an investment account in commercial paper.
However, by structuring the accounts so that the net asset value (NAV) remained an even $1.00 per share, and by offering withdrawal slips that were backed by a commercial bank, the money-market accounts had the look and feel of a checking account.
Money flowed into the money market accounts and out of commercial banks. The commercial banks protested the unfair advantage offered by investment banks and investment companies and argued that the current legal system threatened the very existence of the banking system.
Congress agreed, and allowed commercial banks to begin offering money market accounts directly. These accounts were exactly designed to mimic the investment bank and investment company money market accounts, by holding short-term collections of commercial paper.
However, this established a precedent of banks being able to invest in short-term liabilities not backed by hard assets or a long-term contractual payment schedule.
The Elimination of Glass-Steagall Restrictions
Once commercial banks had been granted permission to engage in the short-term securitization of securities (which is what a money market account is), they began petitioning for the elimination of the rest of the Glass-Steagall restrictions on their abilities.
Over time, this occurred. Banks were allowed to create their own mutual funds, to trade in open markets using their own capital, and to package loans into new securities and resell them.
Ironically, one of the strongest vocal opponents of the relaxation of the Glass-Steagall Act in the mid-1980s was Paul Volcker, who was then chairman of the Federal Reserve.
In fact, in 1987, part of Paul Volcker’s argument was that loosening the banking restrictions would lead to the following:
- Lenders will "recklessly lower loan standards in pursuit of lucrative securities offerings”
- Lenders will “market bad loans to the public”
These quotes are from 1987.
It is ironic to look back now and realize that Volcker foresaw the “subprime” mortgage loan problem and the resale of mortgage-backed obligations into tranches, which could be sold to individuals in $1,000 increments, marketed as “insured” and, therefore, better than Treasury securities.
The Volcker Rule - Reforming Prior Deregulation
What Paul Volcker predicted when Congress relaxed the restrictions on commercial banks is precisely what came to pass.
Commercial banks increasingly became able to securitize loans, particularly mortgages, and had a strong incentive to “juice” the returns of the mortgage-backed securities by adding high-rate subprime mortgages to the package.
The fact that Fannie Mae was doing the exact same thing, forcing commercial banks to follow suit, is often not mentioned in mass media coverage of the mortgage market collapse.
Commercial banks even became allowed to acquire investment banks, and vice-versa, which then marked the complete erosion of the Glass-Steagall Act restrictions on banks.
(Note that we identified the erosion of the Glass-Steagall Act as the core of the problems in an Ahead Of The Curve column dated Sept. 18, 2008, “Would Glass-Steagall Have Helped?”)
What is now called the Volcker Rule, is really just a partial reinstatement of the restrictions on commercial banks that were first enacted in 1933.
Congress might like to point to the Dodd-Frank Act passed in 2010 as “financial reform,” but you will rarely hear a politician admit that the “reform” being enacted is really just an undoing of the “deregulation” that Congress previously enacted.
In other words, Congress itself created the very problem, through legislation of the 1980s and the 1990s, that the Dodd-Frank Act now claims to “reform.”
The irony now, of course, is that the Volcker rule enacts restrictions that Paul Volcker himself argued should never have been done away with in the first place.
Section 619 of the Dodd-Frank Act is now referred to as the “Volcker Rule” in honor of the arguments made by Paul Volcker both today and in the past.
When we review the history of financial regulation, however, we think the Volcker Rule might better be called the “I Told You So” rule.
Comments may be emailed to the author, Robert V. Green, at email@example.com