Is the Volcker Rule Working After All?

One of the most controversial parts of the summer's financial regulation bill was the so-called "Volcker Rule." Developed by former Federal Reserve Chair and departing head of President Obama's Economic Recovery Advisory Board Paul Volcker, the rule sought to forbid depository institutions from investing for their own account ("proprietary trading"). But Congress and lobbyists ended up altering the rule, watering it down to where it would be a much more lax standard for banks to comply with. Despite weakening the rule, however, new evidence indicates that it could be affecting proprietary trading in a less tangible, but still significant, way.

There were a couple complaints about how the Volcker Rule evolved in the financial regulation bill. One criticism is that the limits it set on proprietary trading were too low to have much impact. Another was that banks could find loopholes to the language used. These flaws might not be as fatal as Volcker Rule supporters thought, however. John Maggs from Politico reports that banks already noticing a change even before the rule has been put into effect:

But officials at the top banks say they are already losing talented traders to hedge funds in anticipation of the new regulations, which they say will put their clients' money at risk and leave the financial system itself less prepared to deal with the next crisis.

On Monday, two rising stars at Goldman Sachs involved in proprietary trading joined nine others who have left the firm since last fall to work at different hedge or private equity funds. All of the traders cited the diminished opportunities for earnings under the Volcker rule.

Maggs goes on to also explain that the Securities Industry and Financial Markets Association has produced a study showing market making activities will be hurt by the Volcker Rule, depending on how the final rule is implemented. If a loose definition of proprietary trading is used, then some common types of bank transactions, like buying big blocks of stock ultimately to be sold to clients, could be forbidden.

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So really, there are two separate things going on here. The first is that some of the best traders at banks see a more difficult regulatory environment in the future and are consequently jumping ship. After all, why stay at Goldman Sachs or Citigroup when you can do the same thing at a hedge or private equity fund without all the red tape? This isn't necessarily fatal to banks proprietary trading: they can just hire new, less talented traders. It does put them at a profound disadvantage, however, if the most brilliant traders are fleeing the banks. This could result in proprietary trading becoming a less significant part of bank profits and strategy.

The second problem is a more tangible one for market efficiency. If banks aren't able to make markets as effectively, then this could ultimately harm liquidity. It's too soon to know for sure if we should worry about this, however, since the final rule isn't out. If banks' worst fears are realized, however, then it could further harm their position as market makers, and instead drive investors to funds or private equity firms that face less regulatory constraint.