Volcker rule

Most o people in banking world would have heard this term and the below pictures also gives  some hint about this topic. After 2008 crash there are lots of reforms in US financial world to avoid recession similar to earlier ones.

Volcker rule is part of Dodd frank regulatory policy and it is to bring commercial banks into good olden days (In plain vanilla term I can say only deposit and loans). In one word I can say stopping commercial banks in speculative investments but still they can hedge (no speculation). And also this rule helps to draw clear boundary between commercial banks and investment banks. I have used a lot of financial terms here and I will explain those in this post so that it will help the person who are not familiar with those terms. Let us see everything in detail in this post hopefully I will convey my thoughts in easy understandable manner so that it will help to enlighten the people who read this!

OH!! Then what went wrong in commercial banking world during 2008. Is there any learning’s from earlier recession?

Answer is pretty simple: YES YES!!

Before digging more, let’s look at few terms.

Investment banking:

Investment banks specialize in large and complex financial transactions such as underwriting acting as an intermediary between a securities issuer and the investing public, facilitating mergers and other corporate reorganizations, and acting as a broker and/or financial adviser for institutional clients. Major investment banks are Goldman Sachs, JP Morgan, Citigroup etc.

Commercial banks:

A financial institution that provides services, such as accepting deposits, giving business loans and auto loans, mortgage lending, and basic investment products like savings accounts and certificates of deposit.

Hedging:

In derivative world hedging plays an important role. Hedging means minimizing the risk associated with the investment or trade (reducing the loss). Hedging means insuring yourself against a negative event to reduce the loss. Remember, the goal of hedging isn’t to make money but to protect from losses.

In layman terms let us look an example to understand more.

We are buying insurance for our bikes or cars, to insure yourself against accidents, theft etc.

Speculative:

These are the people in trading world who wants make money only by betting. These people whose ultimate motto is to make money not like hedgers they are in trading to reduce the risk in investment.

Proprietary trading:

When a firm uses its own money for trading to make profits. Trading means selling/buying stocks or bonds, derivate instruments etc.

Lessons we learned from 2008 crisis is that most of the financial firms did proprietary trading using customer’s money not their own money. Especially commercial banks forget their core business i.e.) they did trading using customers deposited money under the assumption that they will make only profit but the game ends in different scenario.

Let us move into Volcker rule now.

What is Volcker rule?

Federal Reserve chairman Paul Volcker formed this rule under Dodd Frank regulation and the core aim of this rule is that commercial banks should not do proprietary trading however they can do hedge trading in government securities (T-bills and bonds).

I did few googling and found that the Volcker Rule is based on the Glass-Steagall Act of 1933.

Glass-Steagall had two major prongs:

1. The creation of the FDIC, which guarantees consumer deposits up to a certain amount.
2. The separation of commercial and investment banking institutions.

As per rule 1, all the deposits in US bank are insured up to 250,000 US$. To learn more about this, refer the below link

https://www.fdic.gov/about/learn/symbol/

In India, all the bank deposits are insured by Deposit Insurance and Credit Guarantee Corporation (DICGC). But insured amount is very less and it is 1 lakh INR.

Refer the below one for more understanding

http://www.dicgc.org.in/english/FD_A-GuideToDepositInsurance.html

In Glass-Steagall act point 2 is not followed by financial institutions that leads various impact in 2008.

Are we happy now ?

Because Volcker rule is implemented hence we can avoid certain crisis again? I can say yes, but still there are few holes in that rule. Banks can’t make speculative trades, but they can hedge existing bets using techniques virtually indistinguishable from speculative trades. There is big debate always finding out whether trade is hedge trade or speculative. By using this loophole still banks are able to play their part.

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. Do you think it is possible? Then banks cannot pay huge salaries and bonuses!!

Let us see how dice rolls in the future. Now even Hillary also coming out with different form of Volcker. Rules are getting tightened day by day and investment banks are getting screwed every day. For Hillary proposal refer the below link.

http://www.vox.com/2015/10/7/9473769/hillary-clinton-volcker-rule