The Volcker Rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Intended to reduce risk in banking in the wake of the 2008 financial crisis, the Rule bans short-term proprietary trading by banks and their affiliates, whether performed directly by those entities or indirectly through investments in hedge funds and private equity funds. In his testimony, Whitehead, the Myron C. Taylor Alumni Professor of Business Law, argued that the Rule addresses "the wrong problem in the wrong way."
Though a principal goal of the Rule was to promote more "traditional" banking business instead of risky trading activities, Whitehead observed, the most significant bank losses during the 2008 crisis resulted not from the proprietary trading activities banned by the Volcker Rule but from traditional extensions of credit, especially loans related to real estate. He also argued that the Rule's attempt to separate commercial banking from investment banking was predicated on a misguided hope that the industry could be returned to an earlier model.
"What the Rule fails to reflect," he said, "is change in how credit is provided today, moving from traditional banking to increasing participation by banks in capital markets. This necessarily involves banks' use of their own balance sheets to buy and sell securities as part of a market-making function. Artificially constraining their ability to do so affects the smooth operation of the capital markets."
As a result of the Rule, Whitehead explained, the proprietary trading that banks and their affiliates were forced to eschew was harvested by hedge funds and other, less-regulated (but systemically important) sectors whose activities affect banks. Meanwhile, to make up for lost revenue, banks simply shifted their risk-taking activities to other businesses. Difficulties in interpreting the distinctions made by the Rule have also encumbered banks with costly compliance regimes and wariness toward market-making activities that fall too close to the line of permissibility.
"Particularly in light of the Volcker Rule's substantial costs, it's unclear why banning [short-term propriety trading] from banking entities is necessary. Doing so inadvertently sweeps up a number of legitimate trading businesses, like market-making, and as a result, potentially lowers secondary market liquidity and raises the cost of new capital," Whitehead asserted.
He concluded by suggesting that the Rule be replaced. "Imposing strict capital requirements on a banking entity's trading book, without trying to parse the difference between proprietary trading and market-making, will more efficiently accomplish the same ends—namely a reduction in risk taking—that the Volcker Rule originally set out to do."