In the paper, The Volcker Rule and Evolving Financial Markets, published in the inaugural issue of the Harvard Business Law Review, I question the effectiveness of the Volcker Rule in light of change in the financial markets over the last thirty years. The Volcker Rule largely prohibits proprietary trading by banking entities—in effect, reintroducing to the financial markets a substantial portion of the Glass-Steagall Act’s static divide between banks and securities firms. By removing proprietary trading, the Rule’s proponents expect utility services, such as taking deposits and making loans, to once again dominate the commercial banking business,
There is considerable uncertainty around the scope of the Volcker Rule and its impact on the financial markets, highlighted—but not resolved—by the recently published Financial Stability Oversight Council study. Chief among the concerns is defining “proprietary trading.” Trading activity can vary among markets and by asset class, and so what constitutes a “near term” or “short-term” transaction for one instrument, subject to the Volcker Rule, may be quite different for another. How, if at all, should the Volcker Rule distinguish among them? In addition, different firms employ different trading strategies, and so what would be considered proprietary at one firm may not be the same at another. A firm may also vary its approach to trading based on changes in the marketplace. A longer-term investment, for example, may be resold quickly in the face of an increasingly volatile market. How can regulators distinguish between changes in strategy and prohibited transactions? And how should regulators separate prohibited transactions from permitted activities, such as market-making?
In addition, the Volcker Rule fails to reflect change in the financial markets. The paper argues that the Glass-Steagall model is a fixture of the past—a financial Maginot Line within an evolving financial system. To be effective, new financial regulation must reflect new relationships in the marketplace. For the Volcker Rule, those relationships include a growing reliance by banks on new market participants to conduct traditional banking functions. To date, much of proprietary trading has moved to less-regulated businesses, in many cases, to hedge funds. The result is likely to be an increase in overall risk-taking, absent market or regulatory restraint. Ring-fencing hedge funds from other parts of the financial system may also be increasingly difficult as markets become more interconnected. For example, new capital markets instruments—such as credit default swaps—enable banks to outsource credit risk to hedge funds and other market participants. Doing so permits banks to extend greater amounts of credit at lower cost. A decline in the hedge fund industry, therefore, may prompt a contraction in available credit by banks that are no longer able to manage risk as effectively as before.
In short, even if proprietary trading is no longer located in banks, it may now be conducted by less-regulated entities that affect banks and banking activities. Banks that rely on hedge funds or other less-regulated markets to manage credit risk will continue to be exposed to proprietary trading—perhaps less directly, but now also with less regulatory oversight, than before. The Volcker Rule, consequently, fails to reflect an important shift in the financial markets, arguing, at least initially—and particularly in light of the uncertainty around its scope and impact—for a narrow definition of proprietary trading and a more fluid approach to implementing the Rule.