Safety net for banks
Those two safeguards are a big part of why there were no bank runs during the most recent financial crisis. But it also presented a problem to policymakers, who believed having that safety net under banks encouraged them to make risky bets in global markets in the run-up to the financial crisis, leaving taxpayers and responsible banks holding the bag should those bets fail.
"The big banks do have access to the safety net, in the form of the Federal Reserve discount window, and they can rely fairly heavily on insured deposits to fund their activities," says Jim Barth, co-author of "The Guardians of Finance: Making Regulators Work for Us." "One has to be sure that banks, to the extent they have access to that safety net, don't misuse it."
The Volcker rule, so named because it was suggested by former Federal Reserve Chairman Paul Volcker, attempts to solve that problem by proposing what started as a simple rule: Banks that take deposits can't invest money for their own gain.
"The prohibition of proprietary trading by the big banks is based upon the notion -- I believe the mistaken notion -- that proprietary trading contributed in an important way to the most severe financial crisis since the Great Depression," Barth says.
But during the legislative process, that simple rule quickly ballooned to include a long list of exemptions to protect trading activities that policymakers considered essential to the operation of global markets. Here are some of the key exemptions.
- Banks can invest their own funds in U.S. Treasuries.
- Banks can still engage in risk-mitigating hedging activities.
- Banks can still trade on behalf of customers.
Accommodating those exemptions while keeping the spirit of the law made things difficult for regulators. The Federal Reserve proposal ran to 298 pages, and it still received thousands of pages of criticism from everyone from consumer advocates to foreign banks to financial industry trade groups.
Financial industry objections
It's not surprising a long list of U.S. and international banks, including U.S. Bank, JPMorgan Chase & Co., Morgan Stanley and PNC Financial, and trade groups such as the American Bankers Association object to the new rule, Barth says.
"Banks like to earn profits, not be prohibited from doing so, which the Volcker rule does in part," Barth says.
If the rules are implemented as written, many U.S. banks and foreign banks with U.S. subsidiaries will have to spin off their profitable proprietary trading operations and potentially cut a lot of jobs in the financial industry.