One fundamental principle of financial markets is the relationship between risk and return. This tenet is reflected in the Capital Asset Pricing Model (CAPM), the workhorse of security pricing, where the return required by investors is measured by adding the risk free rate (such as a treasury bond) to a market risk premium, adjusted for the correlation between the security’s risk and market risk conditions over a specified time period (Sharpe & Lintner, 1965). Although empirical tests of CAPM have shown numerous shortcomings (Fama & French, 1992), the model still provides the fundamental framework by which investors commonly view their asset allocation strategy.
Utilizing CAPM as a framework reveals that additional risks must be taken by financial institutions in order to comply with the expectations of investors in a highly competitive market. In an attempt to stem the systemic risks resulting in the Great Recession, regulators finalized the Volcker Rule in December of 2013. The rule is cumbersome, yielding 900 pages of regulation which is ultimately ineffective in addressing the risks associated with banking activities that contributed to the last financial crisis. Furthermore, CAPM fundamentally shows that with an unmodified required rate of return, the aggregate risk will simply result in a risk allocation which could directly harm consumers. Simply put, banks will have to find other ways to meet consumer expectations. It’s no wonder that Goldman Sachs and Bank of America abandoned their market making desk in order to pursue other activities within three months of the rule coming into effect. In order to meet investor expectations, these institutions will look to take more risks in other financial service areas (such as lending or debt instruments.). These activities will only perpetuate the systemic risks that the Volcker Rule should have been preventing in the first place.
Background: What is the Volcker Rule?
The Volcker Rule was initially proposed as a response to the Great Recession by Paul Volcker, a former Federal Reserve Chairman. Now signed into law, the rule prohibits banks from engaging in the proprietary trading of certain financial instruments, namely derivatives, futures, and securities. The following points clarify the definition of proprietary trading, and describe the types of institutions that are subject to the Volcker Rule.
A firm engages in proprietary trading if any of the following points apply:
- The purpose of proprietary trading includes the short-term sale or purchase of derivatives, futures, and securities, either resulting in profit from short-term price movements, arbitrage, or hedging.
- The firm involved in this transaction is licensed to engage in security-based swap deals, either out of requirement or choice. This licensing can be either domestic, foreign, or international in nature.
- The firm is insured by the FDIC, an institution subject to market risk capital rules as set forth by the Treasury Department.
Additionally, the Volcker rule prohibits banking institutions from owning more than three percent of any private equity firm or hedge fund. It was later modified from its initial proposal to make certain exceptions, including:
- Repo and Reverse Repo (agreement to both purchase and sell a given asset at a given price with a client.).
- Securities lending transaction: The banking institution either lends or borrows a given security from an investor, vice versa. These are commonly used in short sales.
- Liquidity management plans in order to ensure sufficient holding quantities of liquid assets
- Employee compensation plans, including deferred compensation and stock bonuses
The premise of the Volcker Rule is simple, in that the US government clearly doesn’t want large banks making risky investments with assets that the FDIC ensures. This rule would place more responsibility upon banks to make shrewd investment decisions with federally insured capital. However, if this is in fact the premise used by the drafters of the Volcker rule, this is the first serious flaw with the rule.
Banks that traditionally combined consumer banking with investment services (Bank of America, JP Morgan) were the ones called upon to buy out the assets of failed trading firms such as Bear Stearns and Lehman Brothers. After the Big Four (Citi, JP Morgan, BoA, and Wells Fargo complied (or in some cases, coerced unethically) with regulators in the face of a financial system on its knees, they were stripped of one of the ways in which the aforementioned institutions systematically create and maintain economic value for consumers. In order to meet the demands of investors, these stable institutions could quite easily be trying to find ways to take risks that aren’t prohibited by the Volcker Rule, which could result in a more complex financial system, similar in nature to the type of systematic investing that created the mortgage crisis in 2007. It was aggressive loan strategies that caused the current financial crisis, not proprietary trading. Restricting the ability of financial institutions to engage in proprietary trading could influence banks to make more aggressive asset investments (i.e. give out more aggressive loans) in order to meet investor expectations, perpetuating the type of activities that caused our current crisis.
This rule and its premise, paired with an American economy stuck in limbo, means that banks will have to resort to other methods of making profit at the cost of liquidity. The Volcker Rule is ambiguous in that it restricts a financial institution’s ability to trade in a proprietary manner. If a bank theoretically chose to move more risky positions to their banking books, banks would be forced to hold risky assets for at least 60 days before being allowed to liquidate. This exposes large institutions to higher degrees of liquidity risk, meaning that banks are forced to hold assets that could pose a threat to consumer wealth, devaluing the very institutions that consumers use for saving and checking services. With the development of increasingly complicated securities (previously a result of securitizing assets that would traditionally be held on a balance sheet) who’s to say that the opposite couldn’t happen with debt instruments, or mortgages? If these types investments are successful, they could create an asset bubble that would affect consumers directly.
With the Volcker rule now in effect, the severity of it will now entirely depend on how the Securities and Exchange Commission chooses to enforce the rule. With banks deciding to sell their market making desks, the SEC could still try to fine institutions for losses made on their trading books that are in any way related to the concept of proprietary trading, even if the capital used could be vaguely tied to retail accounts. This type of regulation could validate an institution’s efforts to shift risky assets to their banking books, forcing them to buy riskier debt securities and other assets that would have a different type of financial risk for which institutions would have to adjust their investing strategy. The ensuing liquidity risk could place consumers in a vulnerable position, as banks will now be forced to find their required rate of return in aggressive debt financing, consumer financing, or other banking book activities.