The Pitfalls of the Volcker Rule

The four main components of the Volcker Rule are meant to regulate the risky activities that traders and investors engaged in with consumers’ money, which were then resolved by using taxpayer money. This rule, since publicized, has been highly controversial because of the damage it will cause to several banks’ businesses. 

A restriction on this practice will, and has already, decreased the amount of profit banks generate. This will in turn force banks to find other ways to make money whether it is charging higher fees to clients in the commercial bank, or other practices that may affect consumers negatively despite the regulations’ intention. 

The controversy lies in that the rule is targeted at preventing another financial crisis which some investors and traders believe were caused by bad mortgage loans and not the trading practices themselves. Therein lies the contradiction because if the products were securitized in the first place there would not have been an investment vehicle to be associated with the bad loans themselves. The ingenuity behind the construction of the mortgage-backed security, credit default swap, and other financial instruments involved in the housing bubble are incredible. At the time, this was seen as revolutionary, and many people were benefiting financially from the practices that seemed non-risky to consumers. Moreover, it can be concluded that it was a combination of risky behavior being employed by traders, investors, mortgage brokers, predatory lenders, and people taking mortgages they knew they could not pay for or afford.

The goal of the Volcker Rule, however, is to minimize risk in proprietary trading and other activities in financial services industries that were not foreseen prior to the 2008 financial crisis. Most recently this past summer, it was reported that J.P. Morgan Chase had a loss of more than $2 billion on a credit derivatives trade, a loss that highlighted the importance of implementing and strictly enforcing the Volcker Rule. Although J.P managed to still beat its annual earnings, it was a major loss that would have cost them the entire business. The problem with the Volcker Rule is that many on Wall Street believe it will not minimize risk but will only create more opportunities for risk. Could the rule have prevented the J.P Morgan loss? 

As the Volcker Rule is being finalized many do believe its importance in responding to the J.P Morgan loss. Two officials, Mr. Levin, and Mr. Merkley have stated, “While American families and businesses should be enjoying the protection of the Volcker Rule, your agencies’ ongoing failure to implement these important protections has left them and our economy at greater risk of another financial crisis.” It is clear that regulators believe the Volcker Rule will make a huge difference in preventing scandals like J.P Morgan’s loss this past summer. I believe the trade would have been prohibited and a designated group would have assessed the trade before it was executed. However, in order for these products to be scrutinized closely, they must be understood comprehensively. The Volcker Rule’s legislative proposal has not addressed this entirely, which will prove to create difficulty in managing the risk it is attempting to minimize.  

Restricting certain practices will also allow others to develop products that have yet to exist. Before mortgage-backed securities were introduced derivatives such as swaps were not widely used and understood. Once it proved to be lucrative for traders, and investors it became a widely traded security thus, birthing its existence. These instruments were created to minimize risk for consumers and clients, but the risky behavior of mortgage lenders was attributed to the creation of “bad loans” that many investors were not aware of. In addition, consumers were also taking advantage of opportunities where they could obtain a mortgage loan when they knew they couldn’t afford it. 

Another issue is that it restricts the ability for banks to “hedge” risk by not being able to hedge investors and consumers is being exposed to risk even more. In hedging positions, the investor that is right will have avoided the risk while the other investor assumes it until another hedging practice of theirs turns in their favor. This complex system of minimizing risk can be regulated but not at the level the Volcker Rule expects to. It was a combination of reckless behavior on the investors, consumers, mortgage loaners, traders, and whole institutions that allowed for the combustion of the financial market in 2008.

The Volcker Rule seeks to minimize risk to consumers and regulate proprietary trading and other investing activities of financial institutions. The rule demands the prohibition of some of the activities while enforcing the regulation of others. Nonetheless, financial institutions should have their own risk management programs, which they do, that should increase regulatory oversight within the firms themselves. 

The Volcker Rule will not be able to regulate the financial services industry as a whole even with assigned oversight by the government itself. It should add a component of education and expand the understanding of these complex activities and products to assess risk beforehand, not after. 

In addition, it should work with the risk management divisions of investment banks to strengthen their risk programs so far to create risk metrics and levels of risk to be approved before risky trades are made, like the J.P Morgan case. To avoid what happened in 2008, it is best to regulate from the inside out, as opposed to what the Volcker Rule targets, which is the “street” as a whole. 

There should be an interest in increasing internal regulation that already exists as opposed to external forces that may disrupt the profit structure many of the banks have constructed, which will once again put consumers at risk.

This is the final part of a three-part series with Paybby that delves into the Volcker Rule and the aftereffects of the 2008 Great Recession. Last week, we discussed the risky mortgage and lending practices that led to the 2008 recession. If you missed part one, which explains the Dodd-Frank Act, click here. 

Paybby is a challenger bank founded with the goal of empowering Black and Brown communities to build wealth and gain access to the benefits of banking. Click here to learn more about Paybby.