"Insights Special Edition: Dodd-Frank Rulemaking: Volcker Rule and SIFI Proposals: Postscript: Toward a New Regulatory Environment"

by Skadden, Arps, Slate, Meagher & Flom LLP
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The Volcker Rule was advanced as a means of protecting the public from the risks of negative externalities and the effect of distorted incentives (or “moral hazard”) arising from proprietary trading activities by financial institutions that have access to funding through insured deposits or access to the Federal Reserve’s discount window. Proponents of the ban on proprietary trading offered this description of the rationale: “After taxpayers were forced to bail out banks and other systemically significant financial companies whose proprietary trades went awry, we determined that the economy and taxpayers need strong protections against an increasingly casino-like financial system.” Paul Volcker observed that “adding further layers of risk to the inherent risks of essential commercial bank functions doesn’t make sense … when those risks arise from more speculative activities far better suited for other areas of the financial markets” and that, accordingly, a robust financial system requires regulatory limitations on the proprietary activities of banks to balance the moral hazard implied by the public safety net. The utility of the regulations proposed to implement the Volcker Rule will depend upon the effectiveness of the protections that they provide against these risks, balanced against the costs and unintended consequences that they generate.

Objectives of the Rule and Potential Unintended Consequences

The perception that proprietary trading by banks could cause catastrophic losses was an important impetus to the enactment of the Volcker Rule. Proprietary trading was seen as inherently risky4 and a significant contributor to the financial crisis. Moreover, it was viewed as a source of distraction from the provision by banks of credit and other core services, and a source of unacceptable conflicts of interest between banks and their customers.6 The rule’s architects objected to the use of federal support7 by banks to enable their trading desks to speculate in financial assets. The prohibition against sponsoring and investing in private funds was viewed as necessary to counteract incentives that may impel banks to “bail out” a sponsored private fund and to prevent banks from using such investments to circumvent the proprietary trading ban.

These views are not universally held. Some observers have questioned whether long-term investments (in, for example, collateralized debt obligations, mortgage-backed securities and leveraged loans), which the rules would allow, present banks with a greater risk of destabilizing losses than the short-term trading that the rules prohibit. Others have observed that the rules allow short-term proprietary trading in debt issued by the Treasury or government-sponsored enterprises. Opponents of the Volcker Rule have questioned whether proprietary trading played any part in a financial crisis “caused by the erosion of lending standards and the federal government’s poorly-conceived efforts to subsidize mortgage lending.” In addition, some have questioned whether the risk of loss arising from proprietary trading could be addressed more effectively by other means, such as improvements to the risk-based capital rules or requirements for elevated levels of margin in interbank transactions.2

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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