The Volcker Rule’s unintended consequences

The most profound change in banking regulation since the global financial crisis has been the Volcker Rule, passed four years ago as part of the Dodd-Frank Act in the United States.

The rule aims to reduce imprudent risk-taking by banks by restricting their business models and prohibit risky activities to increase financial stability.

This is done by banning banks from proprietary trading and limiting their investments in hedge funds and private equity.

While full compliance is not required until next year, major affected bank holdings in the US have announced reconfigurations of their business models, shutting down proprietary trading desks and selling shares in hedge funds.

If the reduction of bank risk is an objective of the rule, our findings suggest that the Volcker Rule has so far not led to its intended consequences

However, despite the compliance announcements, the effect of the Volcker Rule could be dubious as the final rules have a long list of exemptions.

Also, as banks can still take risks in many ways such as increasing leverage or risks in the trading or the banking book, or decreasing the hedging of the banking book, it cannot be assumed that a decrease in the trading book or its particular activities decreases banks’ overall risk.

Similarly, regulators may find it difficult to differentiate between prohibited and permitted activities such as trading on behalf of customers, market-making, or hedging.

As a result, affected banks could keep their overall risk levels unchanged.

Based on my research with my co-author Josef Korte this is indeed the case; while the banks most affected by the Volcker Rule have reduced their trading books much more than others, there has been no corresponding reduction in risk-taking because the affected banks use their remaining trading accounts less for hedging.

Possibly because of the continuing trading activities, fortunately the banking book risks have not, or at least not yet, risen significantly.

ThinkAloud4Thus, while the banks are at least closer to complying with the rule so far they have been able to keep their overall risks unchanged.

Further, if the reduction of bank risk is an objective of the rule, our findings suggest that the Volcker Rule has so far not led to its intended consequences.

These effects are not necessarily surprising.

Banks make profits by taking risks and if regulators prevent them to take risk in one way, they do it another way since risk-taking incentives have not changed.

In another paper, my co-author Sohhyun Chung and I show that with the Volcker Rule this risk shifting has unintended consequences; decreasing banks’ equity value and raising their default profitability.

To be fair, the final rulebook for the Volcker Rule has only recently been published and it is not yet fully binding on banks.

However, our results (together with several banks’ self-declared compliance) identify serious risks in the Volcker Rule.

Thus, US regulators might want to analyse further possible implementation risks and unintended consequences to ensure increasing bank, and thereby, financial stability, especially because the rule is expensive for both the banks and regulators.

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