By Netaniel (Nathan) Segal – Financial Solutions Expert

The Volcker Rule was the government’s response to the reckless actions of banks, taking speculative investments using customer’s deposits, leading to the 2008 financial collapse.  Under the regulation, banks can not use accounts for short-term proprietary trading of derivatives securities and commodity futures in addition to options on all of these investments.  

The Rule, which began in 2014, is part of section 619 of the Dodd-Frank Act, with the intention of global control of the market by reducing risk.  Global control is the influence of the economy and system via political measures affecting the demand side of the market and is intended to do more than set an economic activity framework while not contradicting market principles.  The fundamental belief behind the Volker Rule is that speculative trading does not benefit a bank’s customers and, therefore, should be banned.

The Rule’s definition of security was clarified in 2019, and the FDIC amended the Rule in 2020, loosening its restrictions and allowing banks to make larger investments in venture capital funds.  Additionally, the loosening changed capital requirements for derivative trades between the same firm’s units, which would prevent a bank from getting wiped out from bad derivative bets.  This change frees up billions for the financial industry but puts it at higher risk.  

Under the Rule, banks can underwrite, market make, hedge, trade government securities, insure, and offer both hedge and private equity funds while acting as agents, brokers, or custodians.  These services can be provided to customers to generate profits, but not if a risk assessment finds a conflict of interest that exposes the bank to high-risk trading strategies or assets, or if the actions could cause bank instability or financial system instability.

The Rule’s reporting requirements depend on the size of the bank, with larger banks requiring implementation of internal audit rule compliance programs.  These internal audit programs have independent analysis and testing.  Smaller entities have fewer reporting and compliance requirements.  

To satisfy the Rule’s requirements, banks have adopted operating models of testing using internal audits, compliance teams, and engaging external consultants.  One critical aspect of these models is risk assessment, as all regulated firms must adequately address, understand and articulate market abuse risks to their businesses.  The “market abuse risk assessment” is the go-to document for regulators, and to fail such an assessment indicates an undermined control framework.  The risk assessment shapes the selected policies, procedures, and controls implemented, including the surveillance approaches.  Most institutions will have an automated surveillance system to ensure compliance with the Volcker Rule.  

While the Rule does protect the bank’s customers, there is pushback by the financial industry that says the Rule…:

• …never had a cost-benefit analysis done and that the associated costs outweigh the benefits.
• …reduces a bank’s liquidity by reducing a bank’s market-making activities.
• …has difficulty in speculative bet enforcement.

Summery

While there is pushback against the Rule, the intention is solid.  The economy should be safer by preventing speculative trading that could cause an institution or the system to fail.  Banks assess a potential borrower’s creditworthiness to avoid default; the Volker rule is intended to have the same caution in defining a bank’s practices.

About The Author

Netaniel (Nathan) Segal

https://www.nsegal.com/

MBA, MPA , CAMS, PMP, CSPO , CSM

Mr Segal is a highly experienced Financial Expert. He performed variety of roles as a lead consultant in different aspects of the financial industry – Accounting, Retail Banking, Wealth Management application, Risk Management and financial crime solutions.

His Expirence inclueded leading Capital Market projects for major clients in Wall Streets including building data warehouse for fixed income, investment back office, and middle office development for large investment international brokerage banks.