THE VOLCKER RULE
by Priyank Gandhi and Patrick C. Kiefer
Regulators are preparing to implement the Volcker Rule, a key component of the July 2010 Dodd-Frank Act. The rule is intended to reduce the ability of commercial banks in the U.S. to take excessive risks by restricting the types of speculative investments in which they can engage. The activities to be banned have been deemed too risky by legislators, and are purported to be harmful to bank customers, including both institutional clients and depositors.1
The Volcker Rule requires banking entities operating in the U.S. to abstain from all proprietary trading and acquiring an (or retaining an existing) interest in any hedge fund or private equity firm. While nonbank financial companies supervised by the Federal Reserve are allowed to participate in such activities, they are subject to additional capital requirements. Banking entities are allowed to participate in certain exempt trading activities if they are related to instruments issued by the U.S. Treasury or government-owned agencies. Other exemptions include underwriting and market-making activities to meet demands of customers, clients, and counterparties, as well as risk-mitigation and hedging or trading on customers’ behalf. Finally, a banking entity is also allowed to organize and offer a private equity or hedge fund, as long as the banking entity does not guarantee nor insure the performance of the fund.
The rationale behind the Volcker Rule is that in recent years, commercial banks have increasingly participated in speculative activities that involve placing bank capital at risk in search of profits rather than responding to customer needs. Proponents believe that these speculative activities add further layers of risk to what is already inherently a risky business. Advocates of the Volcker Rule argue that speculative activities present conflicts of interest between bank division managers and customers that (based on past experience) are virtually insolvable with so-called Chinese walls between business segments. They propose that these conflicting activities are better handled by other legally distinct participants in financial markets.
Regulators also are concerned that their extensive efforts during the Credit Crisis of 2007 to rescue large financial institutions by extending deposit insurance and lender of last resort facilities to investment banks, mortgage providers, and insurance firms has reinforced the moral hazard problem. Large, complex financial institutions can now always count on public support during times of aggregate economic shocks. Regulators and proponents of the Volcker Rule believe that their actions provide large commercial banks with incentives to increase risk taking, eventually leading to an even more fragile financial system that will be susceptible to ever-more serious crises in the future.2
Similar rules to force banks to divest their risky speculative businesses have been proposed in the United Kingdom and several other countries. In the United Kingdom, the Independent Commission on Banking led by Sir John Vickers requires bank holding companies to erect a ring-fence between their commercial banking and investment banking arms. In the EU, the High-Level Expert Group chaired by Erkki Liikanen, the governor of the Bank of Finland, has proposed that proprietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amount to a significant share of a bank’s business.3
Dodd-Frank and the related legislative proposals are highly complex. In November 2011, four of the five federal agencies charged with jointly implementing the 11 pages of the Volcker Rule in the Dodd-Frank Act put forward a 298-page proposal. Two months later, the fifth agency released its own proposal that was 489 pages long. The shortest version of these proposals required banks to answer 383 questions and 1,420 sub-questions, and could be broken down into 355 “simple” steps.
One issue that highlights how complex it is to implement the Volcker Rule is the distinction between sovereign debt issued by the U.S. Treasury and non-U.S. government bonds. The Volcker Rule exempts U.S. Treasury securities but classifies trading in sovereign debt issued by other countries, even those by EU Nations and Japan, as speculative investments. Regulators in other countries are justifiably concerned that such restrictions will cause U.S. banks to exit the markets for sovereign bonds for those countries, reducing liquidity and hampering the ability of these nations to borrow money by issuing foreign debt. The impact is likely to be particularly severe on smaller nations with thinly traded bonds that rely heavily on large banks to serve as primary dealers to buy their debt at auctions. Regulators in Europe and Japan have clearly indicated that they cannot accept any regulations whose consequences are exported to their countries or they will be tempted to respond in kind, restricting the ability of large foreign banks to hold and trade U.S. Treasury securities.4 The issue has been muddied further by the fact that in an attempt to level the playing field, U.S. regulators require that the Volcker Rule will apply not only to U.S. divisions of foreign banks, but will also cover activities of any bank with a connection to the U.S., even a single branch in one state.
Another issue with the implementation of the Volcker Rule is that it effectively requires regulators to micro-manage how market making—the process by which a market participant accepts the risk of holding a certain inventory of securities in order to facilitate trading in that security by its customers—is conducted by banks in the U.S. Post implementation, U.S. and foreign banks will have to prove that all buying and selling of securities amounts to market making for clients, not proprietary trading.
This has led to an outcry from U.S. banks. Banks complain that it is easy for them to divest independent trading units that are devoted entirely to proprietary trading. However, it is often difficult, if not impossible, to distinguish between proprietary trading and other activities (such as marketmaking and portfolio hedging), and there is a fine line between classifying such activities as trading for their own accounts and buying and selling on behalf of clients. As a result,instead of bearing related regulatory costs, banks may simply decide that it is more efficient for them to exit certain markets altogether. By some industry analyst estimates, the cost of issuing corporate debt may increase annually by $360 billion if banks exit these markets.
In light of the banks' reaction to the proposed rules regarding proprietary trading, it is vital that regulators ask why banks choose to diversify their business models to include trading and market-making in the first place, instead of specializing in a narrower range of activities. The answer to that question may help inform regulators as to the costs of restricting these activities. Hence, in the remainder of this article, we focus on the effect of this diversification on banks' operations.
In academic finance, there is a well established literature that analyzes the costs and benefits of diversification. Academics believe that on the one hand, diversified firms can allocate resources to their best use by forming an internal capital market where the internally generated cash flows can be pooled. Diversified firms can also enhance efficiency because they can fund winners and abandon losers in a way that the financial market cannot do in stand-alone firms. On the other hand, there is evidence that diversification destroys value. Research by Stulz and Lang (1994), Berger and Ofek (1995), and Servaes (1996) shows that diversified firms trade at a lower valuation as compared to non-diversified firms. There is also evidence that segments in diversified firms respond to unanticipated shocks in other segments within the same firm and that investments in one segment are sensitive to the other segments' cash flows, independently of the unexposed segment's investment opportunities. Thus, diversified firms appear to have active internal capital markets, and the capital allocation decisions for a particular segment can reflect the operational successes and failures of other segments.
In particular for a bank, a diversified business model may offer two distinct advantages. First, banks with a diversified business model can offer clients a "one-stopshop," thereby providing better services, gaining valuable client information, and locking in customers by eliminating their need to shop around for different financial services. Second, banks with diversified operations may be able to diversify their risk by gaining access to differentially correlated income streams. This diversification may impact a bank's funding costs as well as its lending decisions. On the downside, diversification of operations can expose a bank to potential conflicts of interest between traditional banking activities and market-making in securities. Large, diversified banks have to manage the increased complexity of their business segments, and this may increase risk-management costs, reduce transparency, and complicate resolution during crisis. Finally, risk diversification allows banks to access low-cost funding and may encourage banks to take on more systematic risk.
There exists a large literature that analyzes some of these issues, but a full review is beyond the scope of this article.5 However, a few key results are worth mentioning. Templeton and Severiens (1992) show that diversified financial institutions are less exposed to income shocks and are more stable. Also, a report by the European Central Bank6 shows that diversified banks fared better during the recent crisis as compared to specialized banks. Cumming and Hirtle 2001 show that complimentary activities at different financial units often serve as natural hedges for each other. On the downside, Kwan, Flannery, and Nimalendran ( 2004) and Iannotta Nocera, and Sironi (2007) suggest that large diversified financial institutions are more complex, less transparent than other companies, and hence may be difficult to monitor. Brunnermeier, Dong, and Palia (2012) report that banks with higher non-interest income contribute more to systemic risk than traditional banking.
The literature on restricting banks from trading and other non-traditional activities is, however, not well developed. While a recent paper by Stiroh and Rumble (2006) finds that diversification by banks has little or no impact on returns, and in fact increases return volatility, it is silent on whether diversification has any significant costs or benefits for a diversified bank's customers. It is here where more research may add value.
In a working paper, we show that for the aggregate banking sector in the U.S., interest income and income from trading activities are negatively correlated.7 Over 1996-2012, the correlation between interest income and income from trading activities was -0.21. This correlation is statistically significant. Furthermore, since we use interest and trading income for the aggregate banking sector in the U.S., it is unlikely that this correlation is spurious or results from is measurement or misreporting of incomes, a phenomenon more likely at the individual bank level.
We also examine the correlation between interest income and trading income for the cross-section of bank holding companies. Of the 1,553 bank holding companies in our sample, the correlation between interest income and trading income was negative for 1,126 bank holding companies or 72.50 percent of our sample. This indicates that bank holding companies (and the aggregate banking sector in the U.S.) effectively employ income from trading activities as a natural hedge to income from lending activities, on average.
We refer to this trading behavior as a natural hedge for the following reason: Income from loans is pro-cyclical, and it is "This indicates that bank holding companies (and the aggregate banking sector in the U.S.) effectively employ income from trading activities as a natural hedge to income from lending activities difficult to form a long loan portfolio that performs well in down cycles. However, when banks have access to trading, positions can be taken to counteract the pro-cyclical exposure of the loan portfolios. Trading positions are more versatile—virtually any exposure can be synthesized—and can be used to hedge the stickier positions in a bank's loan portfolio, thus smoothing income across cycles. Most importantly, even if the divisional managers' trading activities are not explicitly motivated by hedging, rational internal capital markets can operate in such a way that trading activities are undertaken as if hedging were the explicit motivation.
In fact, our most surprising result emerges when we compare the lending behavior of banks that employ trading as a natural hedge to lending of banks where trading and lending incomes are positively correlated. We find that banks that employ trading as a natural hedge are able to maintain more stable lending policies as compared to other banks. To the extent that banks have active internal capital markets, access to trading appears to smooth credit supply across cycles, on average.
We are still investigating the source of this higher stability in lending policies. It may be that banks with more diversified income streams have lower income volatility and are able to maintain more stable investment policies through the active operation of their internal capital markets. If diversified banks have lower income volatility, they may also benefit from lower funding costs. Such banks may also pass on savings from funding activities to customers and hence may be able to provide credit at lower costs. This effect may be most pronounced during economic downturns when the average cost of credit is high or when other banks (with more positively correlated income streams) may be increasing the cost of credit or reducing the size of their lending books.
The motivation of the Volker Rule is to protect depositors and clients from the risk borne by proprietary trading divisions at banks, to mitigate the moral hazard tendency created by the implicit bailout guarantee, and to curb systemic risk. Our preliminary results indicate that the impact of banning prop-trading may feed back into the real economy through credit supply, and thus may adversely impact some of the agents the rule was intended to protect. It is possible that amplifying credit-supply cyclicality by banning trading can make systemic risk more pronounced. Furthermore, firms that rely on bank loans could experience greater financing costs in the presence of barriers to a bank's ability to smooth income. The implications of shutting down these banks' internal capital markets should be studied carefully so that unintended externalities of the law can be minimized.
1) The Volcker Rule refers to Section 619, pages 245 - 256, of H.R. 4173 and is available at http://www.sec.gov/about/laws/wallstreetreform-cpa.pdf.
2) See editorial in the The New York Times by Paul Volcker dated January 30, 2010 available at http://www.nytimes.com/2010/01/31/opinion/31volcker.html?pagewanted=all.
3) See reports available at http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf.
4) See statement by Michel Barnier, the European Union’s financial services chief available at http://www.online.wsj.com/article/SB1000142052970204573704577185100193763384.html.
5) A summary of this literature is offered in the report titled “‘Study of the effects of size and complexity of financial institutions on capital market efficiency and economic growth,” authored by the chairman of the Financial Stability Oversight Council, dated January 2011.
6) See Altunbas, Yener, Simone Manganelli,and David Marques-Ibanez, 2011, “Bank risk during the financial crisis: do business models matter?” Working Paper Series 1394, European Central Bank.
7) For the paper, we utilize data from the FRY-9C required to be filed by all bank holding companies in the U.S. that are insured by the FDIC.
Altunbas, Yener, Simone Manganelli, and David Marques-Ibanez, 2011, “Bank risk during the financial crisis: do business models matter?” Working Paper Series 1394, European Central Bank.
Berger, Phillip, and Eli Ofek, 1995, “Diversification’s effect on firm value,” Journal of Financial Economics 37, 39–65.
Brunnermeier, Markus K., G. Nathan Dong, and Darius Palia, 2012, “Banks’ non-interest income and systemic risk,” Working Paper.
Cumming, Christine M., and Beverly J. Hirtle, 2001, “The challenges of risk management in diversified financial companies,” Economic Policy Review Mar, 1–17.
Iannotta, Giuliano, Giacomo Nocera, and Andrea Sironi, 2007, “Ownership structure, risk and performance in the European banking industry,” Journal of Banking & Finance 31, 2127–2149.
Kwan, Simon H., Mark J. Flannery, and M. Nimalendran, 2004, “Market evidence on the opaqueness of banking firms’ assets,”Journal of Financial Economics 71, 419–460.
Lang, Larry, and Rene Stulz, 1994, “Tobin’s q, corporate diversification, and firm performance,” Journal of Political Economy 102, 1248–1291.
Servaes, Henri, 1996, “The value of diversification during the conglomerate merger wave,” Journal of Finance 51, 1201–1225.
Stiroh, Kevin J., and Adrienne Rumble, 2006, “The dark side of diversification: The case of U.S. financial holding companies,” Journal of Banking & Finance 30, 2131–2161.
Templeton, William K, and Jacobus T. Severiens, 1992, “The effect of nonbank diversification on bank holding company risk,” Quarterly Journal of Business and Economics 31, 3–17.