Volcker Rule Impact

July 8, 2010

Authored by: Jerry Blanchard

One of the ideas incorporated into the Regulatory Reform Act has been the so-called Volcker Rule, named after former Federal Reserve Chairman, Paul Volcker. Volcker’s proposal was that banks should not be engaged in speculative trading for their own accounts. For example, holdings in mortgage backed securities caused huge losses for the nation’s largest banks.

The rule has now made it into the conference committee’s version of the bill although in a somewhat watered down version of what Volcker had originally proposed.  The bill in its current version would prohibit a bank from investing more than 3% of its tier 1 capital in a private equity hedge fund and would also prohibit a bank from owning more than 3% of the equity in such a fund.

As a practical matter, these limits probably work to the advantage of large banks. The limit still allows large financial institutions to invest billions of dollars of their own money in speculative trades.  It may also have the unintended consequence of causing some institutions to move money that they currently have invested with hedge funds and managing the investments themselves.

The rule also contains one very large loophole which is that, except to the extent the federal banking regulatory agencies adopt policies to the contrary,  the limits do not apply to the purchase of US Treasury securities, or of obligations issued by Fannie Mae, Ginnie Mae, Freddie Mac, a Federal Home Loan Bank, the Federal Agriculture Mortgage Corporation, Farm Credit Banks or state and local municipal bonds. While investing in such instruments would theoretically not carry the same risk as investing in mortgage backed securities, there is still interest rate risk inherent in such investments and a wrong bet on which way rates will head could still cost an institution a great deal of money.