The Volcker Rule is a Necessary, but not a Sufficient Condition for Macrofinancial Stability

About five years after the global financial crisis of 2007-2008, the Volcker Rule – a key part of the Dodd-Frank Wall Street Reform and Consumer Protection Act – was approved by the five financial regulatory agencies last week, and is scheduled to go into effect on April 1st 2014.

As widely known, the main feature of the Volcker Rule is the prohibition to commercial banks to engage in proprietary trading, whereby the customers’ deposits are used for trading activities by banks on their own behalf. In this sense, the Volcker Rule has been considered by many as just a partial reestablishment of the Glass-Steagall Act of 1933, which prohibited any institution from acting as any combination of an investment bank, a commercial bank and an insurance company.

While it is true that the recent financial crisis was not caused by proprietary trading by commercial banks, tackling this open flank in financial regulation is vital for the establishment of a sound and sustainable financial system. Indeed, as we discussed in a recent paper (Chiarella, Flaschel, Hartmann and Proaño 2012) in a stylized theoretical macroeconomic framework, an increasing orientation of commercial banks towards trading activities in detriment to their classical lending activity for real investment purposes may lead to financial and macroeconomic instability. The main mechanism behind this outcome is the following: If the banks’ credit supply depends negatively on asset prices (as banks are more likely to engage in proprietary trading when asset prices increase), and the loan interest rate depends positively on the private sector’s indebtedness, an asset price boom leads to a reduction in the supply of credit by banks, but also to a decrease in the loan interest rate, which in turns increases aggregate consumption, aggregate investment (which is increasingly financed by equity issuance instead of new credit) and output, providing further boosts to asset prices. In such a macroeconomic environment, the introduction of a legal framework such as the Volcker-Rule would interrupt this destabilizing feedback mechanism, as banks would be prohibited to use the customers’ deposits for speculative purposes and not for the supply of new loans to the private sector, contributing so to a more stable macroeconomic environment.

Nonetheless, neither the Volcker Rule nor a strict separation between commercial and investment banking (as it was the case when the Glass-Steagall Act was still in effect) may provide by themselves an institutional framework sufficiently strong as to make eliminate the occurrence of banking crises in the future. Indeed, even under prohibited proprietary trading, as long as commercial banks are allowed to invest the customers’ deposits in financial instruments with an unclear risk exposure, financial turmoil episodes like the recent global financial crisis are likely to happen on a recurrent basis, and the banking sector will keep being rescued with taxpayers’ money.

A meaningful extension of both the Volcker Rule and the original Glass-Steagall Act would be the implementation of some sort of variation of the narrow banking idea originally proposed by Irving Fisher in the early 1930s (see De Grauwe 2009, Kay 2011 and Chiarella et al. 2012 for recent contributions along these lines), whereby customers’ deposits could be invested in only safe and liquid financial instruments such as sovereign bonds. Since under narrow banking all checkable deposits would be backed by safe or quasi-safe assets (implying a 100% reserve ratio for this type of deposits), deposit insurance would not be required anymore, and the very rationale of bank runs would disappear. Concerning the other classical role of commercial banks, namely the provision of loans to the private sector, it should be noted that the introduction of a narrow banking framework would not necessarily imply a reduction in level of credit in the economy, as banks could lend to the private sector using their own capital, or by raising further funds in the financial markets to finance their lending activities. As a consequence, banks would carry the lending risk with their own capital, and not with the customers’ deposits anymore.

Even if the narrow banking scenario is a too extreme framework to be implemented any time soon, it highlights nevertheless possible gains with respect to efficiency and stability arising from the separation of commercial from investment banking activities, and from the separation of deposits from the banks’ lending risk.  In this context, the Volcker rule is at least a first step away from the status quo that brought about the great recession of 2009, towards a system featuring resilience to bank runs and speculative misbehavior of commercial banks, but enabling a sufficient loan supply to entrepreneurs and providing term transformation services for ordinary bank clients.

Given the uncontrolled financial market deregulation process that was undertaken all around the world over the last thirty years which finally lead to the U.S. subprime crisis in 2007 and the worst worldwide economic recession since the Great Depression of 1929, the introduction of the Volcker Rule is a remarkable step towards the enforcement of macrofinancial stability, as it may help to reduce the propagation of financial instability into the macroeconomy. Its operational implementation will be a medium-term process which will surely posit great challenges for regulators, but it is a task worth to pursue.

Christian Proaño – The New School for Social Research, New York

Florian Hartmann – University of Osnabrück, Germany

Carl Chiarella – University of Technology, Sydney

Peter Flaschel – Bielefeld University, Germany

Literature

Chiarella, C., Flaschel, P., Hartmann, F. and C.R. Proaño (2012). Stock market booms, endogenous credit creation and the implications of broad and narrow banking for macroeconomic stability. Journal of Economic Behavior & Organization 83, 410-23.

De Grauwe, P. (2009), Lessons from the Banking Crisis: A Return to Narrow Banking. CESifo DICE Report 2/2009.

Fisher, I., 1935. 100% – Money. Adelphi, New York.

Kay, J., 2011. Narrow Banking. Unpublished manuscript available online at http://www.johnkay.com/wp-content/uploads/2009/12/JK-Narrow-Banking.pdf.

One Response to "The Volcker Rule is a Necessary, but not a Sufficient Condition for Macrofinancial Stability"

  1. Adam_Smith   December 23, 2013 at 9:47 am

    Really trying hard to credit the Volcker Rule with being a step forward despite it being a very big step back from the wisdom of the Glass-Steagall rules.