Policy Documents

The Volcker Rule and Evolving Financial Markets

Charles K. Whitehead –
June 1, 2011

The Volcker Rule prohibits proprietary trading by banking entities - in effect, reintroducing to the financial markets a substantial portion of the Glass-Steagall Act’s static divide between banks and securities firms. This Article argues that the Glass-Steagall model is a fixture of the past - a financial Maginot Line within an evolving financial system. To be effective, new financial regulation must reflect new relationships in the marketplace. For the Volcker Rule, those relationships include a growing reliance by banks on new market participants to conduct traditional banking functions.

Proprietary trading has moved to less-regulated businesses, in many cases, to hedge funds. The result is likely to be an increase in overall risk-taking, absent market or regulatory restraint. Ring-fencing hedge funds from other parts of the financial system may be increasingly difficult as markets become more interconnected. For example, new capital markets instruments - such as credit default swaps - enable banks to outsource credit risk to hedge funds and other market participants. Doing so permits banks to extend greater amounts of credit at lower cost. A decline in the hedge fund industry, therefore, may prompt a contraction in available credit by banks that are no longer able to manage risk as effectively as before.

In short, even if proprietary trading is no longer located in banks, it may now be conducted by less-regulated entities that affect banks and banking activities. Banks that rely on hedge funds to manage credit risk will continue to be exposed to proprietary trading - perhaps less directly, but now also with less regulatory oversight, than before. The Volcker Rule, consequently, fails to reflect an important shift in the financial markets, arguing, at least initially, for a narrow definition of proprietary trading and a more fluid approach to implementing the Rule.