Research & Commentary: Proprietary Trading and the Volcker Rule

Published June 21, 2012

Proprietary trading is a common financial activity that is currently being targeted for additional regulation in the aftermath of the 2008 financial crisis and several high-profile losses by major banks from their proprietary trading desks. In proprietary trading, a financial firm trades financial instruments such as stocks, commodities, or derivatives with its own money, not its customers’, to make a profit for itself. This is different from regular trading, where the bank’s profits come from commissions for processing trades. 

Former U.S. Federal Reserve Chairman Paul Volcker and other advocates of increased government intervention argue speculation at proprietary trading desks of many banks played a key role in the financial crisis of 2008. Volcker recommends new restrictions forbidding U.S. banks from making certain kinds of speculative investments that do not benefit their customers. 

These provisions, known collectively as the Volcker Rule, were made law in the Dodd-Frank Financial Reform Act and are scheduled to take effect July 21, 2012. The Volcker Rule forces separation of the investment banking, private equity, and proprietary trading sections of commercial financial institutions from their traditional consumer lending divisions. 

The rule also prohibits financial institutions, or companies that own a bank, from engaging in proprietary trading not done specifically at the request of its clients. Commercial banks also will be forbidden to own or invest in a hedge fund or private equity fund. The rule also will limit the amount of liabilities the largest banks and financial firms are allowed to hold. Designed to manage risks in the financial system, the Volcker Rule is intended to increase transparency in the system and make it easier to regulate. 

Critics of the Volcker Rule argue it will be incredibly difficult to enforce, have little effect on systemic risk, and could cut banks’ competitiveness. The vagueness of the rule could lead banks to undertake even riskier investments, they say. These concerns and others have convinced the Federal Reserve to at least slow implementation of the Volcker Rule. The Fed will now allow banks to delay full compliance until July 2014, though the banks will be required to show they are preparing for full compliance. 

The following documents examine proprietary trading and the Volcker Rule from various perspectives. 

Volcker Rule May Make the Financial and Banking System Riskier
David C. John of The Heritage Foundation writes about the Volcker Rule and the Fed’s delay of full implementation. John argues today’s financial markets are far too complex for such limitations to work and the longer it takes for Congress to recognize this fact, the greater the damage the Volcker Rule will cause to the financial system—and the more likely that much of that damage will be permanent. Congress should not use the regulators’ delay as an excuse for inaction, he writes; it is time to recognize the Volcker Rule is deeply flawed and repeal it.

The Volcker Rule: Not the Solution to Reducing Financial Risk
In a WebMemo, David C. John of The Heritage Foundation compares the Volcker Rule to past financial reforms. John argues the rule will do very little to improve the stability of the banking system and would have done absolutely nothing to prevent or even reduce the impact of the 2008 financial crisis. Worse, John argues, the rule could damage the U.S. financial system. 

Would Volcker Rule Stem Systemic Risk?
In a podcast hosted by Caleb Brown, Mark Calabria, director of financial regulation studies at the Cato Institute, discusses the Volcker Rule and whether it will stem systemic risk. Calabria argues the Volcker Rule would not have stopped the 2008 crisis and says proprietary trading restrictions may make the financial system more risky. 

The Volcker Rule and Evolving Financial
Writing in the Harvard Business Law Review, Charles K. Whitehead of Cornell Law School argues regulatory models such as the Volcker Rule and Glass-Steagall are fixtures of the past. 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. Whitehead argues the Volcker Rule 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. 

The Volcker Rule and its Impact on the U.S. Economy
Testifying before the House Financial Services Committee, Douglas J. Elliott of the Brookings Institution contends the Volcker Rule is fundamentally flawed and will do considerably more harm than good. He notes it attempts to “eliminate excessive investment risk at our core financial institutions without measuring either the level of investment risk or the capacity of the institutions to handle the risk, which would tell us whether the risk was excessive. Instead, the rule focuses on the intent of the investment rather than its risk characteristics.” 

Market Making Under the Proposed Volcker Rule
Darrell Duffie of Stanford University discusses the Volcker Rule’s implications for the quality and safety of financial markets. Duffie argues investors and issuers of securities would find it more costly to borrow, raise capital, invest, hedge risks, and obtain liquidity for their existing positions. He also notes nonbank providers of market-making services eventually would fill some or all of the lost market-making capacity, but with an unpredictable and potentially adverse effect on the safety and soundness of the financial system. 

Proprietary Trading Is a Bigger Deal than Most Bankers and Pundits Claim
James Crotty, Gerald Epstein, and Iren Levina of the Political Economy Research Institute at the University of Massachusetts-Amherst argue proprietary trading, properly defined and contextualized, had a great deal to do with the financial crisis. They call for the Volcker Rule to be significantly strengthened and broadened to large investment banks and the shadow banking system. 

Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds
The Financial Stability Oversight Council gives recommendations for identifying and eliminating prohibited proprietary trading activities and investments in or sponsorships of hedge funds and private equity funds by banking entities. The council strongly supports robust implementation of the Volcker Rule and makes several recommendations about how to enforce it. 

Making Banks Safer: Can Volcker and Vickers Do it?
Julian T.S. Chow and Jay Surti of the International Monetary Fund (IMF) assess various proposals to redefine the scope of activities of systemically important financial institutions. Chow and Surti argue the Volcker Rule, while promising, entails significant implementation challenges including the potential for activities identified as too risky for retail banks to migrate to the unregulated parts of the financial system. 

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the FIRE Policy News Web site at, The Heartland Institute’s Web site at, and PolicyBot, Heartland’s free online research database, at

If you have any questions about this issue or The Heartland Institute, contact Heartland Institute Senior Policy Analyst Matthew Glans at 312/377-4000 or [email protected].