“Regulatory capital and liquidity requirements for market making are a more cost effective method of treating the associated systemic risk. […] Market making risks, and other risks taken by a bank, are unsafe whenever they are large relative to the capital and liquidity of the bank.”
Darrell Duffie, “Market Making Under the Proposed Volcker Rule,” 2012.
By creating a new regime to limit threats to the U.S. financial system—including heightened scrutiny for systemic intermediaries and a new resolution framework—the Dodd-Frank Act (DFA, passed in July 2010) has made the U.S. financial system notably safer. However, DFA also included burdensome regulations that, in our view, reduce efficiency while doing little to improve resilience. The leading example of such a provision is DFA section 619, known as the Volcker Rule. As Duffie noted well before regulators began to implement the Rule (see the citation above), it is not “cost effective.”
Implementing the Volcker Rule has required extraordinary regulatory attention. In the run-up to the initial 2014 implementation of the Volcker Rule, regulators conducted nearly 1,400 meetings and received hundreds of (unique) letters (see Krawiec and Liu). That version occupied more than 270 pages in the Federal Register. Over the past month, four of the five responsible agencies have approved “final amendments” to the existing Volcker Rule. (The fifth agency, the Federal Reserve, is likely to follow soon.) By expanding exemptions―including for assets that are available for sale and for derivatives not held for trading, as well as for institutions that have no reported trading assets―and by raising the activity threshold for applying the rule, these new changes aim to ease the compliance burden. Yet, the Volcker Rule remains a source of great controversy (see, for example, former FDIC Chairman Gruenberg’s objections to the latest revisions).
Ultimately, the need to focus on this overly complex and relatively ineffective regulation distracts both the government authorities and private sector risk managers from tasks that really would make the system safer. Not only that, but cumbersome rules almost surely increase pressure to ease regulation more broadly. This leads policymakers to scale back on things like capital requirements and resolution plans that we truly need to ensure financial system resilience.
In this post, we briefly describe the Volcker Rule, highlighting its complexity, its tenuous links to risk management, and its apparent negative effects on the financial system.
Taking a step back, in the aftermath of the financial crisis, Congress sought to curtail proprietary trading—or own-account trading—by banks. The motivation was simple: intermediaries that receive the benefit of the federal safety net—including deposit insurance and access to the lender of last resort—ought not use the resulting subsidy to take greater risk at the expense of taxpayers. To achieve this goal, DFA section 619 partially restored the segmentation of financial activities that existed prior to the 1999 repeal of the Glass-Steagall Act.
There is, however, a huge problem in drawing the line: how can you distinguish proprietary trading from market making? Congress aimed to allow the second, but not the first. But, how can you keep banks from gambling with taxpayer money, while still allowing them to provide a service that makes a range of assets (like government and corporate bonds, currencies, mortgage-backed debt, and large blocks of equity) liquid?
Duffie summarizes the difficulty: “market making is proprietary trading that is designed to provide ‘immediacy’ to investors.” (Immediacy is the “ability to immediately absorb a client’s demand or supply of an asset into its own inventory.”) When an investor wishes to buy or sell a financial asset, they typically value the option of trading instantly with a dealer—who puts her own funds at risk—rather than waiting for a broker to find a suitable counterparty. A rule that forbids one category of market maker (in this case, banks) from using their own-resources to trade can diminish market liquidity, shift market making to other types of market makers (nonbanks), or both.
To avoid a loss of liquidity in key markets, the initial implementation of the Volcker Rule excluded a short list of instruments (including government and federal agency debt, municipal bonds and foreign exchange) and activities (including some forms of repo and securities lending). Authorities also made efforts to protect market-making activities more generally. Yet, as Richardson and Tuckman highlight, “justifying that a trade belongs to a permitted category is […] difficult and subjective.” The need to prove that specific trades are permitted led to an enormous compliance effort, increasing the costs (and the deadweight loss to the economy) imposed by the Rule.
To illustrate the complexity of compliance, consider the recently amended proprietary trading flowcharts designed by leading law firm Davis Polk to guide compliance. As described on pages 7 to 10, the process for determining whether an activity is permissible requires (but is not limited to) ensuring that:
the bank is trading as a principal for its own account and not as a broker;
the trading desk is willing to enter long and short positions in similar financial instruments “in commercially reasonable amounts”;
the market-making activity is “designed not to exceed, on an ongoing basis, the reasonably expected near-term demands of clients, customers or counterparties;” and
trader compensation does not “incentivize prohibited proprietary trading.”
Even if a set of trades satisfies these four (somewhat subjective) conditions, other provisions could still prohibit the activity. For example, a trade is not permitted if it results in the bank holding a “high-risk asset.” In practice, compliance requires daily computation of a range of metrics―including risk management, revenue, and position data―for all trading desks. And, when supervisors inquire, a bank must be prepared to demonstrate compliance, potentially for every single trade.
Not surprisingly, in their study of the Volcker rule, Bao, O’Hara and Zhou conclude that implementation has diminished the willingness of bank dealers to make markets in corporate bonds in periods of stress—precisely when liquidity is most needed. Furthermore, despite weak evidence that dealers unaffected by the Volcker Rule stepped up their market-making efforts, Bao et al find a net decline in overall liquidity in corporate bonds. No less important, Bao et al reject the hypothesis that the post-crisis boost in capital needed to satisfy the Fed’s stress tests contributed to the decline in bank market making. These findings are consistent with those of both Anderson and Stulz, who observe a decline in liquidity in periods of heightened systemic risk (see our earlier post on corporate bond liquidity), and Choi and Hu, who argue that regulation raised corporate bond trading costs for those clients needing liquidity.
Collectively, this research also is consistent with the observed decline in bank trading inventories relative to the volume of corporate bond trading. The figure below depicts a rough version of this inventory/trading ratio. The numerator includes banks’ trading assets (other than government, agency, and municipal debt, mortgage-backed securities, and derivatives) and relevant available-for-sale securities. While corporate bonds are only a subset of the numerator, we suspect that the evolution of the true corporate bond inventory ratio mirrors this broader category.
Ratio of banks’ trading and available-for-sale assets to corporate bond turnover (percent), 2005-1Q 2019
So, the Volcker rule is costly to both banks and their customers. Can we balance this with the benefit of a more resilient financial system? We doubt it. First, as Richardson and Tuckman point out, the Rule exempts corporate loans, but not corporate bonds with the identical counterparty risk. Given the frequency with which bad loans trigger broad financial distress, why assume that trading businesses are necessarily riskier than traditional lending (see, for example, here and here)? Second, if the Volcker Rule really does limit risk-taking by banks, does it reduce overall risk or merely shift it to leveraged nonbanks that provide banking services? The jury is out. And finally, what if market making provides a hedge against risks in other parts of the bank’s business? In that case, the prohibition of these activities would be making banks that scale back market making less safe.
Perhaps the worst impact of the Volcker Rule is to give financial regulation a bad name. Cumbersome and costly rules encourage firms (and their clients) to seek remedies from policymakers. At least since the 2016 election, both elected and appointed officials are clearly listening. Together, they are all looking for ways to ease the burden, even where it is not warranted. As one indicator of this worrisome trend, consider a few recent actions (all opposed by the Systemic Risk Council): the relaxation of resolution-planning requirements (July 2019); the marginalization of the nonbank designation authority of the Financial Stability Oversight Council (May 2019); efforts to ease the enhanced supplementary leverage ratio (August 2018); and the legislated rise in the size threshold for imposing stricter scrutiny on banks (February 2018).
The bottom line: given the Volcker Rule’s loose connection to risk in the financial system, it makes sense for regulators to ease the burden of compliance. However, it will be difficult to limit the negative impact of a rule that is simply not cost effective. Worse, the broader pressure to deregulate threatens to undermine financial resilience, consistent with the historical pattern of “progressive dilutions of core regulatory requirements” that have left the U.S. banking system vulnerable in the past.
Given the choice, our preference is for a simpler regulatory framework with a focus on a combination of higher capital requirements and a shift toward activities-based regulation. The key is to require adequate equity funding of trading activities, and to impose equivalent requirements on any institution engaging in trading for their own account. Speaking directly to the motivation for the Volcker Rule, greater reliance on equity finance would diminish—and potentially eliminate—the value of any unintended subsidy to risk taking from deposit insurance.