The Real Goal of the Volcker Rule

Commentary about business and finance.
Dec. 11 2013 5:33 PM

What the Volcker Rule Really Does

New regulations won’t do much to prevent financial crisis, but they’re a step toward shrinking America’s megabanks.

Former Federal Reserve Board Chairman Paul Volcker arrives at a hearing before the Financial Institutions and Consumer Protection Subcommittee of Senate Banking, Housing and Urban Affairs Committee, May 2012 in Washington, DC.
Paul Volcker is a legendary figure in American finance for his work whipping inflation in the late-Carter and early-Reagan years.

Photo by Alex Wong/Getty Images

On Tuesday, more than three years after President Obama signed landmark legislation overhauling American financial regulation, the five regulatory bodies charged with formalizing the so-called Volcker Rule have reached agreement. The rule is a bit of an odd duck—not that intimately related to the financial crisis of 2007-08, but perhaps crucial to the path forward for regulation of the banking sector.

The rule’s anomalous status in the firmament of Obama-era financial regulation starts with the name. Paul Volcker is a legendary figure in American finance for his work whipping inflation in the late-Carter and early-Reagan years. He’s also a Democrat, and someone the president brought on board in an advisory capacity to lend some luster to his economic recovery efforts. Volcker was never really a key member of the team, and his vision differed in a number of ways from that of Treasury Secretary Timothy Geithner, National Economic Council Chairman Larry Summers, Fed Chairman Ben Bernanke, and other main drivers of economic policy. But Volcker’s notion that financial institutions with insured deposits—banks, in other words—should be prohibited from engaged in the speculative trading we associate with hedge funds was what caught the president’s fancy.  

Finance critics on the Hill liked the idea, too. And even though neither Geithner nor Summers were enthusiastic about it, they both got on the bus eventually.


Then, for years, it languished in bureaucratic obscurity. Congress ordered regulators to write a rule that would ban proprietary trading, in which banks try to make money by buying and selling securities, but allow two very similar things: The first, hedging, means buying and selling securities to offset risks. Airlines, for example, buy oil derivatives to reduce their exposure to the ups and downs of fuel prices. Banks were supposed to be allowed to keep doing this. The other permitted activity is market making, in which a bank agrees to serve as both a buyer and a seller of some security in order to ensure the existence of a liquid market. As five different regulatory agencies had to sign off on the text of a rule, it seemed likely that these exemptions would balloon into enormous loopholes.

But then came a wave of pushback, and a final rule that banks are none-too-pleased with. How you should feel about it comes down largely to how you feel about major banks feeling sad. Beyond that, the arguments both for and against the rule are rather weak.

The big problem with the Volcker Rule is that the underlying presupposition that trading was a major cause of the financial crisis is just wrong. Banks appear to have gotten into trouble for basically the same reason that so many mortgage borrowers ended up underwater: excessive optimism about the trajectory of house prices. Banal mortgage and commercial real-estate lending was the root cause of problems at both large and small banks, and the Volcker Rule does nothing to halt that. It’s a bit of a regulatory left hook, thrown unexpectedly at the industry rather than tailored to address a specific concern.

On the other hand, the banks’ insistence that imposing this rule will somehow devastate liquidity and access to capital across the economy makes no sense. In New York, liquor stores labor under an arbitrary rule that they can’t sell beer. I have no idea what good this rule accomplishes, but it certainly doesn’t prevent people from buying beer. It just means other stores sell beer. By the same token, if banks are forced by regulators to abstain from profitable trades, then someone else will make them. Life will go on; it’s just that some specific firms will be disadvantaged.

And that in some ways is what makes the Volcker Rule important. It’s not a major component of the Obama administration’s core objective of making a giant banking blowup less likely. But it is a step down a road Obama’s largely shied away from—a road where you don’t just try to improve the stability of the financial system but actually try to cut it down to size. A relatively tough Volcker Rule is politically viable because most banks won’t be handicapped by it at all—they’re small- or medium-sized institutions that do little or no trading and are happy to see their larger competitors get hurt. No discernable harm is done to anyone, while the biggest banks shrink a bit.

If advocates of a larger transformation of the financial sector are to get their way in years to come, it will be through a series of Volcker-like measures—somewhat arbitrary, somewhat opportunistic efforts to exploit internal divisions within the banking world to hinder the growth of one sort of firm or another. No single step down this path will be necessary or sufficient on its own terms. But a bunch of them could shift the balance of power in the American economy.


Frame Game

Hard Knocks

I was hit by a teacher in an East Texas public school. It taught me nothing.

Yes, Black Families Tend to Spank More. That Doesn’t Mean It’s Good for Black Kids.

Why Greenland’s “Dark Snow” Should Worry You

If You’re Outraged by the NFL, Follow This Satirical Blowhard on Twitter

The Best Way to Organize Your Fridge

The World

Iran and the U.S. Are Allies

They’re just not ready to admit it yet.

Sports Nut

Giving Up on Goodell

How the NFL lost the trust of its most loyal reporters.

Republicans Like Scott Walker Are Building Campaigns Around Problems That Don’t Exist

Farewell! Emily Bazelon on What She Will Miss About Slate.

  News & Politics
Sept. 16 2014 4:08 PM More Than Scottish Pride Scotland’s referendum isn’t about nationalism. It’s about a system that failed, and a new generation looking to take a chance on itself. 
Sept. 16 2014 4:16 PM The iPhone 6 Marks a Fresh Chance for Wireless Carriers to Kill Your Unlimited Data
The Eye
Sept. 16 2014 12:20 PM These Outdoor Cat Shelters Have More Style Than the Average Home
  Double X
The XX Factor
Sept. 15 2014 3:31 PM My Year As an Abortion Doula
  Slate Plus
Slate Plus Video
Sept. 16 2014 2:06 PM A Farewell From Emily Bazelon The former senior editor talks about her very first Slate pitch and says goodbye to the magazine.
Brow Beat
Sept. 16 2014 1:27 PM The Veronica Mars Spinoff Is Just Amusing Enough to Keep Me Watching
Future Tense
Sept. 16 2014 1:48 PM Why We Need a Federal Robotics Commission
  Health & Science
Sept. 16 2014 4:09 PM It’s All Connected What links creativity, conspiracy theories, and delusions? A phenomenon called apophenia.
Sports Nut
Sept. 15 2014 9:05 PM Giving Up on Goodell How the NFL lost the trust of its most loyal reporters.