The Volcker Rule Explained

The Volcker Rule, part of the Dodd-Frank financial reform bill, seeks to shield bank customers from risky behavior. The theory behind the rule is that it will keep banks from using depositors’ money to make speculative bets, leaving the FDIC and taxpayers to pick up the bill if the trades go south. But does it really accomplish what it purports to?


  1. Definition: What is the Volcker Rule?
  2. Glass-Steagall Act: the Historical Antecedent
  3. The Volcker Rule as Glass-Steagall Lite
  4. What’s Wrong with the Volcker Rule?
  5. A Hedge by Any Other Name
  6. How to Tell a Trade from a Hedge
  7. Why Does Volcker Cover Goldman Sachs and Morgan Stanley?

Definition: What is the Volcker Rule?

Named after former Federal Reserve Chairman Paul Volcker, the eponymous regulation aims to bring commercial banking back into the good old (and pretty boring) days, when all they did was to make loans and take deposits. It intends to prevent banks from making risky (or “speculative”) investments with customers’ deposits – basically, to separate commercial and investment banking. Specifically, it would prohibit commercial banks that are FDIC-backed from:

1. Owning, partnering with or investing in hedge or private equity funds. Bank of America cannot make their speculative trades through a partner fund.

2. Engaging in proprietary trading: speculation using the firm’s own funds with the intention of making a profit rather than mitigating risk. Wells Fargo cannot take on large amounts of auto industry debt, just because it thinks it will be profitable.

However, the act explicitly permits certain activities:

1. Trading in U.S. government obligations. Banks can buy government-backed securities, such as bonds issued by Fannie Mae, Freddie Mac, Ginnie Mae or the U.S. Treasury.

2. Market-making, or placing transactions on behalf of customers. Banks can match up a customer who wants to sell a security and a customer who wants to buy it.

3. Hedging to reduce the risk. If Chase has a large amount of mortgage loans, they face severe losses if interest rates go down. To guard against that possibility, they buy U.S. Treasury securities, which appreciate in value if interset rates fall.

Scheduled to be implemented on July 21st, 2012, the Volcker Rule probably won’t go into effect anytime soon: Federal Reserve Chairman Ben Bernanke said that he and other regulators won’t be able to draft the rules in time.

Glass-Steagall: the Historical Antecedent

The Volcker Rule is based on the Glass-Steagall Act of 1933, which limited speculative activities by commercial banks and was repealed in 1999 under the Clinton Administration.

Glass-Steagall had two major prongs:

1. The creation of the FDIC, which guarantees consumer deposits up to a certain amount.

The FDIC guarantees consumer deposits up to a certain amount (currently $250,000). The organization helped to prevent bank runs, which are panics that result when people think that their bank is going to fail. Afraid that they’ll lose their deposits, they race to pull out their money, and in doing so actually cause the bank to fail. The FDIC’s backstop prevents this loss of confidence.

2. The separation of commercial and investment banking institutions.

The second, better-known provision of Glass-Steagall prevented commercial banks from owning, partnering with or sharing leadership with investment banks, and vice versa. Commercial banks could not trade in securities, except for U.S. government bonds. The sponsoring congressmen criticized banks for taking risks with consumers’ deposits and hoped to restrict commercial lenders to their core functions.

But over the years, legislation and federal regulation chipped away at Glass-Steagall’s firewall. By the time the Gramm-Leach-Billey Act of 1999 formally repealed the bill and opened the door to merged commercial and investment banks, many experts believed the Depression-era law already dead.

The Volcker Rule as Glass-Steagall Lite

Still, some regulators and academics blame the 2008 financial crisis on Glass-Steagall’s repeal, at least in part. Their efforts to reinstate the commercial-investment firewall culminated in the Volcker Rule. It’s often called Glass Steagall-lite, though, because whereas Glass-Steagall prevented a certain type of institution (a bank like JPMorgan Chase, which takes deposits and makes trades, would be prohibited), the Volcker Rule prevents a certain activity (JPMorgan could still exist, it just wouldn’t be able to make certain types of trades). The Volcker Rule would also apply to Goldman Sachs and Morgan Stanley, the two biggest investment firms. But there’s one problem.

The Volcker Rule is rendered essentially meaningless with one loophole: banks can’t make speculative trades, but they can hedge existing bets using techniques virtually indistinguishable from speculative trades.

What’s wrong with the Volcker Rule?

If the Volcker Rule worked the way it was intended, a bank’s profit would only be derived from the difference between interest earned on loans and interest paid on deposits. Back in the Glass-Steagall days, bankers followed the 3-6-3 rule: they paid 3% interest on deposits, made 6% interest on loans, and left at 3:00 to play golf.

But Bank of America and its peers have a much more complicated balance sheet. They might hold mortgages in Montana, Australian auto loans, American student debt and Chinese currencies, not to mention derivatives of all of those products. A 3-6-3 banker can count on simple math: interest in is higher than interest rate out, so there’s a profit. But if a market unexpectedly tanks, Wells Fargo might find itself out of money. To protect against that, banks hedge: they take the opposite position, so that if one part of their portfolio loses money, another will gain some of it back. Hedging is vital to these banks’ solvency, and thus to Americans’ access to capital, so the Volcker Rule allows this practice.

For these giant financial institutions, hedging is incredibly complex. Ph.D’s draw up intricate mathematical models that say if X happens, you’ll lose $Y. However, if you invest in securities A, B and C, you’ll actually make $Y in the case of X, so your bets are hedged. These models are vast and nuanced, and there’s little way of knowing if they actually worked the way they were supposed to. A bank can claim that virtually any trade was a hedge, since they deal in so many securities that it’s impossible to clearly pair up each trade with its offset. And if every trade can be called a hedge, a ban on trading is no ban at all.

A hedge by any other name

When is a hedge not a hedge? Critics of the Volcker Rule contend that banks could trade to their hearts’ content, knowing that regulators would never be able to definitively separate speculation and hedging. Consider JPMorgan’s infamous London Whale trade, which is losing $3 billion and counting. The blog FT Alphaville reasons that the trade was meant to earn money if the market went down. Given that the bank’s $100 billion in assets include everything from plain-vanilla auto loans to a derivative-flavored alphabet soup of financial products, JPMorgan wouldn’t have to look very far to find a part of their portfolio that earned money if the market went up. So, was this a proprietary trade meant to earn a tidy profit? A hedge that went wrong? Or a hedge that went right, because the offsetting position earned $3 billion and the system worked as it should?

a. It’s a prop trade: One trader decided that the market was probably going to fall. If he’s right, the firm makes billions and he gets a hefty year-end bonus. He had profit on his mind, not risk management.

b. It’s a hedge that went wrong: As JPMorgan’s CEO Jamie Dimon said on a conference call, “The original premise of the synthetic credit exposure was to hedge the company in a stress credit environment. Our largest exposure is credit across all forms of credit…[but] it was badly executed.”

c. It’s a hedge that went right: Given the many moving parts in JPMorgan’s $100 billion operation, who’s to say that the trade was a bad idea? Sure, the trade looked bad, but if they hadn’t had that position and the market had gone the other way, they could have lost even more.

If Jamie Dimon has to stand before a congressional committee and explain why the trade complies with Volcker, he can do so with ease. Not even bankers understand the complex calculations behind hedging; it’s impossible to expect legislators to. But one man has a solution.

How to Tell a Trade from a Hedge: Follow the Money

The central question that will determine Volcker’s efficacy is this: how can you tell an illegal prop trade from a legal hedge? Andrew Lo, a professor of finance at MIT’s Sloan School of Management, has an answer for regulators:

There is one very simple question that you can ask — which has a definitive answer — about the small number of individuals who were responsible for managing this group at JP Morgan: How were they compensated? Were they paid a salary and a bonus, and was the bonus a function of the profitability of the group, or was the bonus a function of the hedging ability of the group?


Lo’s point is this: the firm will incentivize desired behavior. If JPMorgan rewards profitable trades, they’re looking to make a profit, so they’re engaging in prop trading. If they reward mitigation of risk, they’re making a perfectly legal hedge. In the end, he says, we’ll have to change our mindsets, not just our laws.

Risk management is not a profit center; it’s typically a cost center. At the same time, CEOs and CFOs make decisions based on what they think shareholders want right now…price appreciation. When you invest in a serious risk-management effort, you spend a lot of money in the short run, and won’t necessarily be able to identify the blowups you avoided because of that effort. That’s why we need to change our culture.

Shareholders want profits, so they reward CEO’s who produce short-term gains. CEO’s want those short-term gains, so they pay traders based on profit, not risk management. As long as those incentives are in place, regulations like the Volcker Rule will be fighting an uphill battle: they try to curb incentives, rather than replacing them.

Side Note: Why does Volcker cover Goldman Sachs and Morgan Stanley?

No one has a Goldman debit card or a Morgan savings account, so why does the Volcker Rule apply? After all, it only pertains to institutions backed by the FDIC. The answer: karma. Before the financial crisis, there were three other major investment banks: Bear Stearns, Merrill Lynch and Lehman Brothers. JP Morgan swallowed Bear Stearns, BofA took Merrill, and Lehman – well, you know that one. Goldman and Morgan were on shaky ground as well, so the Federal Reserve declared them to be banking institutions and provided them access to cheap, easy loans from the Fed. That designation kept Goldman and Morgan afloat in 2008, but now, it’s a liability: as bank holding companies, they’re subject to oversight under the Volcker Rule.

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