Right Facts, Wrong Interpretation: The Volcker Rule and Systemic Risk

21 Mar 2019
Read Time 5 mins
Categories :
Volcker Rule

Recently, staff economists at the Federal Reserve released a research paper that uses bank-level data to evaluate, according to the authors, “whether trading increases or decreases systemic risk in the U.S. banking sector.”  The authors conclude that “the Volcker Rule was an effective financial stability regulation” as they argue that the Volcker Rule had the effect of reducing systemic risk in the banking sector.  We strongly disagree with this conclusion.

While the authors are correct to say that banks have reduced risk, the reduction in risk and attendant reduction in the provision of financial services is a cause for concern that demonstrates the unintended and costly consequences of the Volcker Rule.  Moreover, these costs and consequences have been so significant as to prompt a much needed and overdue overhaul of the rule by regulators.

The authors use data from large, U.S. banks on trading revenues to estimate how the sensitivity of trading revenue to financial market risk factors – factors such as equity prices and interest rates – changed after the imposition of the Volcker Rule in 2014.  The authors’ main empirical finding is that large U.S. banks reduced their exposure to equity market risks following the enactment of the Volcker Rule.

Consider the data in Figure 1 that shows both the dollar amount of gross trading assets (in blue) as well as the Value-at-Risk (VaR) (in orange) associated with Forum members’ trading assets.  Both the dollar amount of gross trading assets and the amount of risk in those assets, as measured by VaR, has declined steadily over the last few years.  These facts are not controversial, are widely known, and are generally in line with the more academic findings presented in the staff research paper.  The interpretation given to these facts by the authors, however, is problematic and should be of concern to policymakers as well as households and businesses that rely on large U.S. banks to facilitate their access to capital markets.

Source: Federal Reserve Y-9C and FFIEC 102, available at https://www.ffiec.gov/nicpubweb/nicweb/HCSGreaterThan10B.aspx
Note: Value-at-Risk data from FFIEC 102 is not available until 2015 Q1


The staff researchers conclude that the observed decline in bank financial market risk is evidence that the Volcker rule is an effective financial stability regulation.  This claim is problematic for two reasons.

First, banks assume risk in their trading book to facilitate client transactions.  When a pension fund needs to sell equity holdings to fund cash payments to pensioners, a large U.S. bank holding company may purchase the equity from the pension fund and hold it in inventory until someone else, like a mutual fund manager, wants to buy those equities.  By purchasing the equities from the pension fund, the bank is assuming risk for as long as the equities remain in its inventory.  If banks actively decide not to assume that risk due to regulatory constraints, then banks will be less able to hold these equities in inventory and clients, such as the selling pension fund or the buying mutual fund, will suffer as a result.  Reducing client access to capital markets does not serve the purpose of, or translate into, reducing systemic risk.

Second, the staff research paper appears to equate “risk” with “systemic risk.”  This sounds like an academic point, but it is not.  All banks assume risk whether it be held in the form of loans, securities or derivatives.  Not all risks, however, are systemic risks and simply asserting that a decline in risk implies a decline in “systemic risk” does not do justice to the important debate around how to measure and manage systemic risk.  After all, we could immediately achieve a significant reduction in bank risk by prohibiting banks from making loans or holding securities to facilitate client transactions.  Such a policy, however, would raise and not lower systemic risk as it would crimp banks’ ability to channel credit to the real economy.  Systemic risks are risks that are directly tied to, and could threaten the operation of, the economy and can’t be managed well by any single institution.  Business risks that are constantly monitored, managed and subject to enhanced capital and liquidity requirements should not be immediately branded as “systemic risk.”  Finally, while the authors claim to assess systemic risk, they essentially compute the reduction in bank risk from a stock market decline, which measures normal business risk that is subject to a variety of compensating controls.

Rather than suggesting that regulators have somehow improved financial stability with the Volcker rule, the paper’s results should be a cause for concern as they suggest that the Volcker Rule is materially impinging on the ability of banks to facilitate client needs.  The measured reduction in bank risk directly relates to a reduced ability to facilitate client transactions which ultimately impedes savings and investment in the real economy.  Indeed, The Dodd-Frank Act foresaw this problem and exempted all market-making activities that facilitate client needs from the Volcker Rule.  As a result, a well-crafted Volcker Rule would not, in any way, reduce the ability of a large bank to, say, facilitate the sale of equities for a pension fund.  In practice, the banking agencies, banks, and their clients have found the Volcker Rule to be an overly complex and costly rule that regularly complicates the facilitation of client transactions.

These problems have been well-documented by academic researchers.  In particular, a previous BankNotes blog post profiled several research papers (including research conducted by Fed staff) that find that the Volcker Rule is having a material and detrimental effect on capital market liquidity.  In addition, both the U.S. Treasury Report and the OCC’s 2017 information collection that sought public input on the Volcker Rule recognized that the Volcker Rule is having a deleterious impact on financial market functioning.  As a result of these well-documented shortcomings, the banking agencies proposed a number of fixes to  the Volcker Rule in October 2018 in hopes of dealing with these problems and improving the rule.  Accordingly, while the paper’s authors may regard the Volcker Rule as an effective financial stability regulation, it is reasonably clear that academics, the U.S. Treasury, the banking agencies, banks, and bank customers needing capital market access do not.

The Volcker Rule bans proprietary trading by U.S. banks.  All Forum members fully comply with this requirement but recognize that its implementation has curtailed their ability to service the capital markets needs of their clients.  As a result, the Volcker rule is being reconsidered by the regulators.  The observed reduction in financial market risk identified by the staff research paper should not be interpreted as a benefit to society, but a cost.  Rather than reduce systemic risk, the Volcker Rule has increased the cost of capital market access for households and businesses, which has itself impaired the provision of credit to the economy.  Ultimately, households and businesses would benefit considerably if the Volcker Rule were revised to better allow banks to take well-managed risks on behalf of their clients.

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