What is the Volcker Rule?

Explaining the Volcker Rule

This April, the U.S. financial sector will be subjected to an extensive set of new regulations that will aim to avoid a major economic meltdown like the world witnessed in 2008. Called the Volcker Rule, it is the centerpiece of the larger Dodd-Frank financial reform law.

All of these new rules and reforms hope to make the financial industry more transparent and take away U.S. banks’ ability to participate in high-risk investments. The rule aims to separate the activity of banks and hedge funds, a line that had become blurred during the run up to the financial crisis. Here’s what the rule means going forward.

What Is The Dodd- Frank Financial Reform?

As mentioned, the Volcker Rule is part of a larger Act called, Dodd-Frank Wall Street Reform and Consumer Protection Act. It’s a long title but simply put, it lays out changes that the U.S. government felt were necessary after the 2008 financial crisis brought the global economy to a standstill. The major reason for the crisis was a dramatic slide in home prices across the U.S. For years, banks, investors and other financial firms had been betting on home prices always rising and therefore giving them all ample reason to bet on the housing market. This excessive optimism coupled with over-zealous lending policies led to the housing price bubble. When it burst, it affected the whole country – not only the homeowners and lenders. The reforms in this act aim to raise the standards the U.S. financial operations, and avoid such bubbles from forming again.

The Addition Of The Volcker Rule

After the reform was passed into law, President Barack Obama still wanted addition provisions put into the act. Obama first proposed the rule in 2010, but it took until December 10, 2013 for it be approved by all necessary parties. Named for the man who championed it, Former U.S. Federal Reserve Chairman Paul Volcker, the rule prohibits banks for engaging in trading that is not in their clients’ best interests. It also prohibits banks from owning more than three per cent of a hedge fund or private equity firm. The rule also aims to stop banks from using depository money on risky investments, like they did with mortgages before the financial crisis.

Not All U.S. Banks Supportive

American Financial institutions will now have to come clean about any risky securities they own. This includes the complicated collaterized debt obligations (C.D.O.) that we heard so much about during the economic meltdown. Taking huge risks is the most lucrative side of the financial industry and without the ability to use deposited money in a number of different ways, banks will see an impact on their bottom line.

Now when a bank takes a position with its own money it will need to prove that is acting to offset a risk. Whereas before, a bank could take a position with its own money regardless of how it would affect its lenders and clients. A bank can no longer give out a mortgage it knows is risky and then turn around and bet that mortgage will fail. It’s this type of investment situation the Volcker Rule aims to prevent.

The Impact On Canadian Lending Practices

Any financial institution with operations in the U.S. will be affected by all the new reform in the U.S. This includes the provisions that will come in place in April under the Volcker Rule. The rule aims at banks trading for their own profits, but most banks do so under the understanding that this mitigates the risk they are taking by lending billions of dollars out.  Most Canadians institutions have welcomed the Volcker rule and are happy with some provision that have been put in place; for example it does not affect the trading of Canadian government bonds by Canadian banks. Canadians intuitions have some options, they can move operation out of the U.S. or if they decide to stay they will need to implement a new layer of compliance that will exist to make sure the new rules are being followed.

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