Does the Volcker rule lower risk?

That’s banks doing proprietary trading for their own accounts, which was limited by Dodd-Frank.  But have those limitations been effective?  Maybe not, at least that is what Jussi Keppo and Josef Korte suggest in their newly published paper:

We analyze the Volcker Rule’s announcement effects on U.S. bank holding companies. In line with the rule and the banks’ public compliance announcements, we find that those banks that are affected by the Volcker Rule already reduced their trading books relative to their total assets 2.34% more than other banks. However, the announcement of the rule did not reduce the banks’ overall risk taking. To keep their risk targets, the affected banks raised the riskiness of their asset returns. We also find some evidence that the affected banks raised their trading risk and decreased the hedging of their banking business.

I would not consider this the final word, but those results are hardly a surprise.  Trying to control bank risk-taking on a limited number of margins is likely to misfire, given the possibilities for other portfolio adjustments.

Most of all I find it striking how many people have strong opinions on the Volcker rule, one way or another, simply because they feel they ought to be on one “side” of the issue.


More comments needed on this post.

One way of looking at this is that the Volcker rule is a watered down Glass-Steagall act, with X% rather than 0% nexus between traditional banking and investment banking allowed. Perhaps going back to 100% Glass-Steagall would work? My pet theory is that equity should be favored over debt. Debt by definition, as Piketty realized, requires growth to be greater than the interest rate, which is not always possible in tough Great Stagnation / structural adjustment times, leading to problems like inequality and periodic runs on the bank. And keep in mind money is largely short and long term neutral and the Keynesian multiplier is near zero or even negative, so government cannot solve this problem.

The argument I hear for banks to take on more equity at the expense of debt always sounds compelling to me.

@C - right you are, though there's a distinction between banks having more equity on their balance sheet (a good idea to be sure) and equity rather than debt being used between consumers. The former is an easy fix, the latter will take a generational 'sea change' of attitudes. But I understand in China (or so they say, maybe Hong Kong) businesses issue equity rather than take out loans from a bank. That's a good thing IMO.

If the tax code changed debt could be made a lot less preferential to equity. Apparently that's part of Trump's corporate tax reform proposal.

"Regulation Q" was far more effective at preventing bank risk taking. That imposed caps on interest rates paid and charged.

Friedman argued that getting rid of Regulation Q would lower interest rates on personal loans and make them more available, plus result in savers being paid higher interest rates than the 4-5% caps of Regulation Q.

So, today, personal loans are lower at 35% vs 12% then?

And savings accounts pay essentially 0% instead of the lower 4% then....

And then, banks screwed you over with free checking at 10 cents a after being lured in by a free toaster, but today banks charge $15 a month to the fools who got free checking then, plus charge $3 a check that isn't a check from a cost saving electronic transaction instead of processing a bit of paper through multiple banks back to you in the mail.

And on top of that, Friedman argued that banking would be much safer with zero risk of bank runs by eliminating FDIC. Thus the shadow banking system with non-FDIC money market funds ensured zero bank lending risk and zero bank Runs!

Oh, yeah, breaking up the banks would make banking safer, like in 1987 after Regulation Q was effectively eliminated, the thousands of small banks were totally safe and never made bad loans and never suffered bank runs.....

Glass-Steagall was still fully in effect until AFTER the massive bank crisis that was fixed by a massive bank bailout called TARP in 1990 to clean up the mess of thousands of failed banks artificially carved out as S&L on the basis that the risk capital, the people in the community, would make sure bad loans were not made.

And I listen with great interest to the economic crisis in Italy caused by the prohibition of bank bailouts which both left and right conservatives call for based on the bank investors deserving to be screwed over. Retirees who have their savings in bank savings accounts, bank bonds, and bank stock are now solely dependent on their government pension because they can't get their savings from the banks. And the banks can't make loans to anyone, not can they let businesses get access to their deposits to run their businesses.

At age 69, I have seen the results on multiple debates on banking policy, and I can say with confidence that Friedman was totally wrong, and that by extension means every conservative economist has been proved wrong.

Which is a victory for this liberal who looks at reality to understand the world, not dogma and history erasure. Anyone who fails to discuss banking from 1982 to 1992 is being purposely dishonest.

Do I understand correctly that the key notion is that banks that enjoy federal deposit-protection should be prohibited from high-risk activity? That seems a defensible quid pro quo to me, as long as a sensible way can be found to define, police, and enforce such a prohibition. Given how corrupt the federal government is, is that qualification attainable?

It isn't high risk activity. Most "prop trading" is a series of small trades that are low risk and earn small profits -- or that hedge a bank's overall risk.

If the goal was to limit high risk activity, they would limit the size of prop trades or limit a bank's overall portfolio size/leverage ratio.

" It isn’t high risk activity. Most “prop trading” is a series of small trades that are low risk and earn small profits — or that hedge a bank’s overall risk". [SNIP]’s-london-whale-saga/

'small trades': CHECK

'low risk': CHECK

'small profits': Heh Heh*

UPSHOT: you're a real expert on the capital markets

* where I'm from, this is called a US$6.2B loss, betting with depositors' money

carlospin, so you are from a place where JPM made a 6.2Bn loss, betting with depositors money. This is very interesting. If that was really the case, either depositors lost money or FDIC had to step in to bail them out. Neither of which happened on planet Earth. I am curious, which planet are you from?

The activities can be separated.

The deposit insurance does not have to be related to areas of business which involve speculative trading. Of course when you're talking about the same corporate entity, the insurance in the one area of activity may enable greater risk taking in other areas when balancing the overall situation.

I don't see why the deposit insurance cannot be separated from higher levels of risk by some regulatory separation of activities and/or pools of assets, etc. It makes sense that within the same large financial company, there will be complementary expertise with the effect that it makes sense for deposit, investment banking, insurance, etc. activities to be allowed in the same business (the Canadian case has some different considerations because of market size and anti-monopoly concerns, but anyways we went ahead with similar rules and the sky has not YET fallen). But why cannot this be separated into two investments?

Basic deposits are to be insured, but we want people to be able to take risk, but not have to bail them out ... can't you have two sets of shares and books, etc., for example "Citybank basic consumer investment and financing" to be treated as separate from "Citybank advanced financial services"?

Unfortunately, there does not seem to be a "best of both worlds" sort of solution.

@dearieme, Troll me: right, moral hazard is a big deal, and here's a paste from a finance book on this issue. The takeaway is that First World countries don't apparently have a problem with deposit insurance, thought this book passage was probably written before 2007. That said, notice that even in the USA that FDIC deposit insurance only really 'took off' in the late 1960s, when, perhaps not coincidentally, risk 'took off' (Bretton Woods falls, Friedmanite floating exchange rates introduced, Regulation Q relaxed in the early 1980s, late 1980s S&L crisis, other bubbles, yada yada not to mention productivity slowed and labor wages stagnated, then there's Woodstock...coincidence? Or all the result of moral and otherwise hazard? Hippies/Boomers at fault again? RL

Box: The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing?
For the first 30 years after federal deposit insurance was established in the United States, only 6 countries emulated the United States and adopted deposit insurance. However, this began to change in the late 1960s, with the trend accelerating in the 1990s, when the number of countries adopting deposit insurance doubled to over 70. Government deposit insurance has taken off throughout the world because of growing concern about the health of banking systems, particularly after the increasing number of banking crises in recent years (documented at the end of this chapter). Has this spread of deposit insurance been a good thing? Has it helped improve the performance of the financial system and prevent banking crises? The answer seems to be no under many circumstances. Research at the World Bank has found that on average, the adoption of explicit government deposit insurance is associated with less banking sector stability and a higher incidence of banking crises.* Furthermore, on average it seems to retard financial development. However, the negative effects of deposit insurance appear only in countries with weak institutional environments: an absence of rule of law, ineffective regulation and supervision of the financial sector, and high corruption. This is exactly what might be expected because, as we will see later in this chapter, a strong institutional environment is needed to limit the incentives for banks to engage in the excessively risky behavior encouraged by deposit insurance. The problem is that developing a strong institutional environment may be very difficult to achieve in many emerging market countries. This leaves us with the following conclusion: Adoption of deposit insurance may be exactly the wrong medicine for promoting stability and efficiency of banking systems in emerging market countries. *See World Bank, Finance for Growth: Policy Choices in a Volatile World (Oxford: World Bank and Oxford University Press, 2001).

Rwanda is an interesting case for developing institutional environments where finance can succeed. It turns out that accountants and lawyers might be useful for something ...

Banking and oil are probably the only two industries I would rather see under state monopoly. They are already government-enforced oligopolies, their losses are socialized and, as János Kornai (what a name!) pointed out, they are at the heart of capitalist economic activity, they are the commanding levellers of the whole economic activity, so stands to reason they have to conform themselves to a more constructive social rule.

Except that state owned oil companies are run horribly, inefficiently and pollute like crazy.

I can't imagine a government run bank except that I see all the politicians and well connected with huge amounts of money they never pay back.

Brazil has lots of government-controlled banks (major shareholder) and historically had lots of regional state banks. They are/were not worse than their private counterparts. And if a country treats state endeavours as the politicians' private piggy bank, well, this country has worse problems than the banking system. We have the Petrobras (state oil company) scandal AND the private civil companies scandal (bribing the politicians to get fat contracts -- a governor and their cronies alone got a 1 billion reais). Banking is a government-enforced oligopoly. In such a situation, it makes no sense talking about "competition". Price controls are the adequate solution.

Oh really?

Thiago, I have to say your constant shilling for Brazil is tiresome, whether or not it's tongue in cheek. You need new material.

In general, government run banks seem to have a fairly poor track record recently. See Germany, Italy, etc.

"I can’t imagine a government run bank.."

The Commonwealth Bank of Australia was owned by the Commonwealth until 1991. Also, there were State owned banks in every state of the country.

Oligopolistic aspects of despoit-taking institutions are not "enforced oligopolies" in most Western countries, except perhaps in the sense that small organizations would never be able to earn a profit and satisfy all regulatory requirements at the same time.

Somehow this distinction seems important even if the outcomes are basically the same. Something about not needing to be on the list of the 5 approved deposit taking institutions (something like exists in many economies) but instead that any business which can earn a profit under those rules can try. Which implies competition, which keeps prices down and incentives to develop better solutions, which is basically what we want. Now ... are there too many rules? No idea.

I don't think so. When Mr. Krugman said American banks and similar institutions (pre-Reagan) did not engage in risky business because they didn't want to risk their charters, he was talking about something like taxicab medallions. He clearly blames S&Ls (that got the right to offer higher interest rates than before) for being the 80's Uber.

How are the losses of privately owned oil companies socialized?

Interesting to see a Brazilian defending the model of a state run oil company given the recent scandals. My experience of IOCs (Shell, Exxon etc) are that they are the corporate equivalent of Mormons, incredibly correct in their behaviour, very smart and professional, and basically the antithesis of evil people. Of course if, like Mormonism, you basically disagree with the entire premise of their business, you can oppose them, but there is no case where you can accept the production of oil and then say IOCs are bad.

One governor and his gang alone got more than 1 billion reais in bribes from private construction companies. Meanwhile, the Army Engineering Corps don't pay bribes. Take a wild guess which one I like the most.

I am pretty sure the Iranians don't remember this story the way you do.
Oil companies basically bleed Third World countries dry. There is good reason to allow foreign competition when there is specialization involved (our airplanes are every bit as good as American ones, but our attempts to design Brazilian cars were failures). But we are talking about money buried in the sand -- the technolgy already axsts, and étrobras designed a good chunck of it itself. There is no reason to give free money to rich foreigners.

A more devout Christian than I am may disagree.concerning what is "correct behavior".

'The technology already exists': and by what ineffable mysteries was that effected?

By investment of the Brazilian government, Brazil is one of th leaders in deep-waters drilling.

In this case, I was thinking about banks, actually, which were the post theme. Oil is a valuable natural resource, so it makes sense to keep it under the nation's control.

I oppose the Volcker Rule when the Dow is at 19,000 but support the Volcker Rule when the Dow falls to 6,600. Can anyone explain to me why economists believe they can predict the future when they are so ignorant of the past.

When the market tanks, all regulations should be abolished. As the market rises and the business cycle lengthens, the screws should tighten.

Ah, an Austrian. Our friends at Mercatus (some of them anyway) oppose intervention (i.e., inflating the value of assets) by the central bank and the government when markets are collapsing. If I had tenure, I would too. Unfortunately, I don't. Do you?

Most people have no opinions on this rule one way or the other. Don't know who you are talking about.

I am skeptical of taking some measurement of risk through observation during normal times. While it is all the data we have when times are normal, it is not a measurement of what the government is trying to purge from these institutions. Bank runs usually require catastrophic risk, which i do not think is measured here.

If I understand correctly, there is wiggle room for regulators to downgrade the assessed quality required to meet minimum/maximum percentages in different risk tranches, and different types of risk, if firms are known to do a bad job at this.

I think there are a few near-experts on here who might even know the right words to easily find exactly what all that adds up to in the Basel 3 and/or Dodd frameworks.

I would support removing limited liability structures from banks.

And automatic tar & feathering of any politician, economist or bureaucrat who even thinks in his sleep that tax payer money should be used to bail out bankers.

Sounds worth debating, although seems a little out of left field.

I'm inclined to think that focusing greater possibility of civil or criminal actions against executives might be cheaper/easier. Nothing against executives per se, but I observe that executives can make decisions which cause billions in damage to people, not by matter of accident, but by matter of calculation where they seek profit with disregard for costs and risks to be faced by others.

I do not understand why this should not be considered as criminal.

If I fail to upkeep my car, and the lack of upkeep ends up as a criminal negligence causing death for the fact of having received many warnings, etc., then I would be more likely to face stronger legal sanction than if an executive did it a million times over.

I get that they have lots of responsibility and this should not be applied to some dumb level. People will make mistakes.

But, take the case of J&J and their illegal marketing which results in significant death and destruction among a great many thousands of patients who were improperly informed of risks that were known by the company and which were required by law to be disclosed (except they had been covered up).

Executives get a strong share in the gains but often no share in the risk. I propose that the risk element should include higher probability of legal sanction for cirminal behaviours, which can only be transmitted by actually tossing some people in prison.

When you have to ruin as many lives as Madoff to start getting real time behind bars, too many other people will assume they can get off scott free. Which they do.

Fantastic post Tyler, it elicited exactly the reply you predicted, even though you predicted it the text of the post.

Well played sir, well played!

Alain, so you believe in nothing, therefore anything? Reminds me of a study by economists that purported to show mechanical refrigeration was 'no big deal' since, adjusted, back before refrigerators they had iceboxes. And for Arizona you can use a swamp cooler and/or eat salted and canned food. Nothing new under the sun, everything I ever learned I learned by the first grade, and other such jaded nonsense...

Prop trading had nothing to do with the great recession

But the banks needed to be punished.... ineffectively

"I can’t imagine a government run bank.."

The Commonwealth Bank of Australia was owned by the Commonwealth until 1991. Also, there were State owned banks in every state of the country.

oops, duplicate comment

" Prop trading had nothing to do with the great recession.."

Yes, and AIG Financial Products & credit default swaps never happened

AIG Financial Products: never heard of it.

The risk is from having a highly leveraged asset portfolio, how quickly one churns it is immaterial. Buy hold is just as risky.

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