On Tuesday, after more than three years of delay and intense lobbying, the U.S. Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the FDIC, and the Office of the Comptroller of the Currency are finally expected to finalize the language of the Volcker Rule.
The rule is named after Paul Volcker, who served as chair of the Fed for nearly 10 years (August 1979 to August 1987) under Presidents Jimmy Carter and Ronald Reagan. Volcker has earned a place in history as a brilliant economist and Wall Street watchdog, and during his tenure at the Fed, he is perhaps best remembered for curbing rampant inflation.
As chair of President Barack Obama’s Economic Recovery Advisory Board (February 2009 to February 2011), he is also remembered for the provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
In broad strokes (and in spirit), the Volcker Rule prohibits depository banks — those protected by the Federal Deposit Insurance Corporation — from risky proprietary trading, investing Tier 1 capital in private equity or hedge funds, and abusing derivatives for hedging purposes aimed only at increasing profit and not done in the interest of customers.
The Volcker Rule is similar to the Glass-Steagall Act in that it seeks to regulate how commercial banks handle risk; it ensures that any losses incurred from proprietary trading do not ultimately fall on the shoulders of the taxpayer. Or, to put it more simply, it seeks to end “too big to fail.” The Glass-Steagall Act was passed in the wake of the Great Depression in an attempt to curb the kinds of abusive profit-seeking strategies that the Volcker Rule seeks to regulate.
“The phrase ‘too big to fail’ has entered into our everyday vocabulary,” Volcker wrote in a 2010 op-ed for The New York Times. “It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks.”
In the minds of critics, many of the problems with the current financial system are well formed and are addressed by the Volcker Rule. At the core of it all, a number of Wall Street reformers believe that the root of all evil — that is, the fundamental cause of crises like the one that happened in the late 2000s — is greed and an excessive pursuit of profit that inevitably creates a tremendous amount of collateral damage.
The Glass-Steagall Act was effectively repealed in 1999 with the passage of the Gramm-Leach-Bliley Act, which removed the barriers between banks and securities and insurance companies that were established by Glass-Steagall. Many observers of the late-2000s financial crisis have cited this development as a major reason why the financial system destabilized.
The Gramm-Leach-Bliley Act was one of the things that allowed financial institutions to become too big to fail by conflating the roles of commercial banks, securities firms, and insurance agencies, also allowing them some degree of protection under the government taxpayer umbrella.
“As things stand,” Volcker said in 2010, “the consequence [of too big to fail] will be to enhance incentives to risk-taking and leverage, with the implication of an even more fragile financial system. We need to find more effective fail-safe arrangements.” Theoretically, one of those arrangements is the Volcker Rule.
In a speech he delivered at the Pew Charitable Trusts on December 5, U.S. Treasury Secretary Jack Lew weighed in on the issue and painted the regulatory mission of the Volcker Rule as an attempt to strike a delicate balance.
“With the completion of the Volcker Rule, resolution authority, and stronger capital and liquidity requirements, the tools of financial reform are being used to make our financial system safer and to hold financial institutions responsible for bearing their own risk without the backstop of public support,” he said. “Regulators have worked hard to find the right balance that protects our economy and taxpayers while also leaving room for well-functioning financial markets that fuel growth and help the private sector create jobs.”