Volcker rule: Why it matters to consumers

This article was originally published by Bankrate.com on Friday November 11, 2011.

By Katherine Reynolds Lewis • Bankrate.com

Halting proprietary stock trading

Federal regulators in early October proposed new regulations aimed at stopping banks from trading for their own profit.

The so-called Volcker rule, named after former Federal Reserve Chairman Paul Volcker, is part of last year's Dodd-Frank Act, the sweeping financial reform law approved by Congress last year.

While high finance and hedge fund investments may seem far removed from your everyday life, consumer advocates and analysts say the stakes for the new law are high. Ultimately, the outcome matters to your pocketbook. Already, JPMorgan Chase & Co., Goldman Sachs and Morgan Stanley have closed or announced plans to shut down their proprietary trading divisions in anticipation of those activities being banned.

With the Office of the Comptroller of the Currency accepting comments on the proposal through Jan. 13, 2012, here's your chance to weigh in on guidelines for the U.S. financial system. The Volcker rule could affect your financial life in several ways.

Promoting bank stability

The overriding aim of the Volcker rule is to promote stability in the banking system and help to prevent a repeat of the financial crisis in 2008. The near-collapse of Lehman Brothers and American International Group, or AIG, prompted Congress to pass an unprecedented $700 billion government bailout in 2008.

"At the end of the day, what this ought to do for consumers is lower the risk of defaults that we saw and maybe make financial institutions easier to regulate," says David Min, associate director for financial markets policy at the Center for American Progress in Washington, D.C.

By forcing banks to stop trading for their own accounts, the rule will limit the amount of risk these mammoth institutions take on, making another financial scandal less likely. "We won't have this kind of financial blowup again, which is good for everyone," Min says.

"This speculative activity drives a bit of a 'heads I win, tails you lose' approach," he says. If banks must compete based on the banking, checking and lending services they provide -- as opposed to the revenue they can generate from proprietary trading -- consumers should benefit.

Banks focus on banking

The Volcker rule aims to make banks focus on their core products and services rather than on racking up profits from exotic trading strategies and complex financial products known as derivatives. If successful, that effort could improve services for customers and lessen the risk of deposits being lost because of the volatile world of high finance.

Before the banking crisis came to the forefront in 2008, traders and investment bankers had focused too much on boosting profits and reaping fat annual bonuses as a result, rather than concentrating on core banking functions, consumer advocates say.

"What is the financial system's job? Is it to provide capital for business, homeownership and economic growth, or is it to generate extremely high bonuses for its senior employees?" says Lisa Donner, executive director of Americans for Financial Reform in Washington, D.C. "We had moved to a world where the latter was too much the case."

Fewer conflicts of interest

Another key goal of the Volcker rule is to eliminate conflicts of interest at financial institutions by separating proprietary and customer trading and by making top executives responsible for seeing that the bank follows the regulation.

For instance, during the housing boom, some investment banks selected loans to package into securities, sold the securities to their customers as low-risk investments and then bet against their customers by making trades that would pay off if those securities lost value.

"That's so egregious, it's kind of mind-blowing," Min says. "The Volcker rule has some strong language about conflict of interest and this strong directive about not engaging in proprietary trading."

The concern is whether the exemptions allowed by the Dodd-Frank law end up being so broad that they lessen the impact of the rule. "It has to be written in a way that's sufficiently narrow," Donner says. "We thought the proposed rule was too weak, but of course there was pressure to make it even worse."

For instance, the proposed rule would let banks trade if they are meeting short-term needs of clients, subject to monitoring programs aimed at spotting banned proprietary trading. There are also exemptions for commodities and certain fixed-income products with a goal to maintain the vital liquidity of U.S. Treasuries and debt issued by Fannie Mae and Freddie Mac.

Cost of transactions

The impact on transaction costs resulting from the Volcker rule is unclear. While the Volcker rule could make financial transactions more affordable to individuals by making banks more like utilities, some experts believe it could drive costs up and reduce liquidity in the system.

Tom Quaadman, vice president of the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness, says it makes U.S. firms less competitive with their European and Asian counterparts who aren't subject to the rule. If investors, including Americans, move their money to overseas banks, there will be less liquidity here.

"It places American financial service firms at a disadvantage," Quaadman says.