The Volcker Rule And You: What’s Your Bank Doing With Your Money?

Dear Reader,

What happens to your money when you put it in a bank?

I remember when I was five years old, watching in awe from the passenger seat of our family station wagon as my mom put my dad’s paycheck into the plastic capsule at the automated teller. She’d place the capsule in the vacuum tube, press a button, and presto: the capsule would be whisked away, Jetsons style.

A minute or so later, the capsule would return with something for everyone: cash for my mom, a lollipop for me, and a biscuit for our cockapoo. Banks were awesome!

As a Casey Research reader, you probably know that (A) banks aren’t awesome and (B) banks don’t keep your money in a vault for safekeeping; they invest it. The much-awaited Volcker Rule that took initial effect on April 1, and will continue to phase in over the next couple of years, changes what banks are allowed to do with your money.

The Intent

The rationale behind the Volcker Rule goes like this:

Banks are FDIC insured—meaning taxpayers are ultimately responsible for any business-threatening losses a bank incurs.

Since banks receive this generous public subsidy, they should stick to activities that benefit the public—like collecting deposits, lending, managing the nation’s payment system, and other low-risk activities that grease the wheels of capitalism.

Therefore, banks should immediately stop engaging in exotic and risky activities—like trading with customer funds—because doing so allows them to rake in profits when their trading strategies work out and to stick taxpayers with the bill when their strategies blow up.

The case seems sound, and the logic has a certain linear appeal. Though I would vehemently argue that FDIC insurance is the root of the problem. Eliminate it, and depositors would have to (gasp!) learn about a bank before entrusting it with their money. Reputation would stop banks from making risky or fraudulent investments. Just like your dry cleaner doesn’t need a law to tell him not to loan out your jeans to another customer, banks that want to retain customers would treat your property with respect.

But I realize that the FDIC ain’t goin’ nowhere... so let’s analyze the Volcker Rule with that reality in mind.

The Volcker Rule aims to force every financial business to make a choice—to be a bank that collects deposits and makes loans, or to be an “other” financial entity that makes riskier investments. You can’t be both.

Economic history buffs will recognize the Volcker Rule as similar to the infamous Glass-Steagall Act, which separated traditional banking from investment banking. Contrary to popular belief, Glass-Steagall was not repealed by Bush, but was whittled down to impotency over several decades and finally put out of its misery by the Clinton Administration in 1999.

The Volcker Rule aims to reinstate some of the principles of Glass-Steagall by restricting what banks can do.

Proprietary Trading

Prop trading is when a bank tries to profit by trading with its “own” funds. I put “own” in quotation marks because the bulk of any bank’s funds is actually customer deposits.

Bank traders’ performance is often the stuff of legend, in no small part because they know what their clients are buying and selling, which gives them an unmatched view of the market. This, arguably, is why Bank of America, JPMorgan, and their ilk can generate hundreds of millions of dollars from trading in a quarter without a single day of losses. Their traders aren’t cut from superior cloth—they simply have more information than you and I do.

But everyone makes mistakes, and bankers have made some doozies. Like when the “London Whale” of JPMorgan lost a whopping $6 billion trading derivatives in 2012. That’s the kind of reckless stuff the Volcker Rule is supposed to prevent in the future.

Easier said than done. Banks aren’t going to stop investing—that’s their business model. They take customer deposits, invest them in securities, pay customers a portion of the proceeds as interest, and keep the rest.

That being the case, the Volcker Rule’s challenge is to separate “sound” investment from “speculation.” Its solution is to prohibit banks from “short-term” trading, which it defines as holding a financial instrument for less than 60 days.

A decent idea on its own—but the evil is in the exceptions.

Exception #1 is that the Volcker Rule permits short-term trading if it hedges risk. So, as long as a trade offsets risk from elsewhere in the bank’s portfolio, it’s A-OK.

The problem is that one man’s speculation is another man’s hedge. Imagine your banker is short $100 million worth of Russian rubles. Ralph the regulator catches wind of it and says, “Hey, stop speculating!” To which the banker will reply, “I’m not speculating. I have a $100 million loan outstanding to a Russian oil company. If the ruble tanks, that business tanks and won’t pay my loan back. My ruble short is a prudent hedge.”

Returning to our London Whale for a moment, JPMorgan claimed its $6 billion losing trade was actually a hedge gone wrong. So would the Volcker Rule have even prevented that disaster—which remains the fifth-largest trading loss in history?

The unsatisfying answer is, “Maybe.” The Volcker Rule narrows the definition of a hedge by requiring bankers to specifically identify what risk a hedge will mitigate, demonstrate the inverse correlation, and monitor its efficacy.

That’s no doubt a hurdle to bank speculation—but one that a determined banker should be able to clear. Banks have gargantuan investment portfolios—if an unscrupulous banker wants to bend the rules, he need only identify which of the bank’s hundreds of thousands of investments has a sufficient inverse correlation to the trade he wants to make.

Voilà. What was a speculation is now a hedge—and is therefore allowed under the Volcker Rule.

Market Making

Exception #2 is market-making—which is when a bank maintains an inventory of securities for customers to buy and sell.

Think of it this way: your grocery store is a market maker. If you’re craving cornflakes, you can go down to Whole Foods and a box will be waiting for you in the cereal aisle. Whole Foods doesn’t wait until you get to the store to call up Kellogg’s to order a box.

Banks do the same with stocks and other securities: they anticipate client demand and buy enough securities to meet that demand—which facilitates liquidity and lowers transaction costs.

Market-making is perfectly acceptable under the Volcker Rule as long as it doesn’t “exceed reasonably expected near-term demands of clients, customers, or counterparties.”

Whenever you see that big “R” word in legislation—”reasonably”—you know there’s some serious wiggle room. Who decides what’s reasonable? What happens if a bank overestimates demand? Did it do it on purpose? Can you prove it?

All unanswered questions that open up opportunities for banks to trade what they want, then justify it later.

The net effect of these loopholes is that regulators will have to judge whether each of a bank’s umpteen-thousand trades per year is a hedge, market-making activity, or “speculation.” Good luck with that. Regulators should be able to catch the most egregious violations, but the bulk of activity will occur in a gray area, where judging a trade’s purpose comes down to intent.

Short of hooking up traders to lie detectors, the Volcker Rule looks almost impossible to enforce.

Who Loses?

The “Big 5” Wall-Street banks—Goldman, Morgan Stanley, Bank of America, JPMorgan, and Citigroup— generate $44 billion in trade revenue per year. Goldman Sachs makes 48% of its revenue from trading, Morgan Stanley 27%, and the other three less than 10%.

We know the Volcker Rule will hurt all of their trading businesses—we just don’t know how much. Several banks have responded by spinning off their prop trading businesses into separate hedge funds. And there are signs of an exodus from banking, with talented executives leaving for the less-regulated world of hedge and private equity funds. The highest-profile exec to jump ship so far is James Cavanaugh, who was supposed to be Jamie Dimon’s heir apparent at JPMorgan, but decided to join private equity firm Carlyle Group instead.

That both businesses and bankers are fleeing Wall Street banks is a good indication that the Volcker Rule isn’t completely toothless. But only time will tell exactly how much it will hurt big banks.

One more thing for those of you wondering why behemoths like Goldman Sachs and Morgan Stanley are subject to the Volcker Rule even though they don’t act as traditional banks. After all, no one I know has a Goldman Sachs debit card or a Morgan Stanley checking account.

The answer is that only certain types of entities were eligible to receive bailout money from the US government during the 2008 financial crisis, and Goldman and Morgan didn’t qualify. So they became bank holding companies to suckle at the taxpayer teat. Now they to have follow the rules for banks.

What Exactly Is the Point?

The bad joke here is that the Volcker Rule wouldn’t have prevented the financial crisis. Proprietary trading losses may have contributed to the crisis, but the primary culprit was mortgage-backed securities (MBS) that turned out to be much riskier than bankers expected.

The Volcker Rule discourages banks from making risky investments… but the MBS that destroyed several institutions were rated AAA, meaning they were supposedly the safest investments around. Some bankers who bought them were trying to invest conservatively—otherwise they wouldn’t have invested in top-rated securities. Other bankers knew the MBS weren’t as safe as advertised. Either way, the Volcker Rule doesn’t solve the problem. I think Mr. Volcker’s face says it all:

The real question is: Is your money safer in the bank with the Volcker Rule than without? There’s no concrete answer, but given that the loopholes are big enough to drive Jamie Dimon’s private jet through, I would say no.

And that’s without even touching on the bigger question of whether legislation is effective in the first place. Do teenagers drink less because of the 21-and-older law? No. But we can save that can of worms for another day.