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Understanding The Volcker Rule

 March 28, 2012 01:42 PM


Many people see the Volcker Rule as the current administration's attempt to make sure that this financial crisis never happens again. But will it work?

Many people see the Volcker Rule, which comes from the 2010 Dodd-Frank legislation, as the current administration's maybe foolhardy attempt to make sure that this financial crisis never happens again. That's true but to an extent.

Its foundation goes back nearly 80 years – to the Great Depression. And it's been an on-going debate as to the freedom we believe our banking system should have.

What is the "Volcker Rule"

The basis of the "Volcker Rule" is to effectively reduce the risk that banks assume. Banks are not allowed to simultaneously enter into an advisory and creditor role with clients, such as with private equity firms. The Volcker rule aims to minimize conflicts of interest between banks and their clients through separating the various types of business practices financial institutions engage in.

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In other words, banks would be allowed to offer depository services to their customers but would be prohibited from investing customer's FDIC insured deposits for the company's financial gain.  The battle cry is "don't gamble in your accounts with our money". The validity of this statement is an argument for another date.

The History…

The Volcker Rule is not avant garde and has been around since the Great Depression in different forms. In order to comprehend the nature behind the rule, we need to look at certain aspects of banking regulation over the last eighty years

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The Banking Act of 1933, more famously known as the second part of the Glass-Steagall Act, was a reaction to the collapse of the commercial banking system of that year in the midst of the Great Depression.

The legislation did two things:

(1)   The Act enforced a separation between commercial and investment banks.

(2)   The Act created the Federal Deposit Insurance Corporation which provides deposit insurance

To protect us from this ever happening again, we needed to separate the investment and lending arms of financial institutions.

However, in the 1980s, there began a movement to deregulate. So why would the government feel it necessary to undo regulation that had stood for over fifty years at that point? A lot of it has to do with pressure from the banking industry. Large banks, brokerages, and insurance companies desired the repeal of Glass-Steagall due to the following rationale.

Individuals put more money into investments during economic peaks. However, in times of economic turmoil, they will place most of their money into savings. With the new Act, they would be able to prosper no matter what the economic climate.

Also, many of our global economic competitors did not have to deal with these restrictions in their home lands. The industry saw Glass-Steagall as a barrier to their international competitiveness.

In November 1999, Congress passed the Financial Services Modernization Act, better known as the Gramm-Leach-Bliley. The Act repealed Glass-Steagall and once again allowed for the consolidation of commercial banks, investment banks, securities firms and insurance companies.

And with our current economic crisis, it is believed by some (including the current Administration) that Gramm-Leach-Bliley was the catalyst for our banking collapse. The "Volcker Rule" aims to restore some of the particulars of Glass-Steagall.

It's not 1933 anymore

Yet, with deregulation starting around 13 years ago, standards have been put in place were we may not be able to regulate as before. Is it possible to separate complex institutions (that have been previously co-mingled with depository, investment and insurance arms) and if we do what will be the repercussions? I believe the Volcker Rule may be rooted more in populist anti-Wall Street fervor rather than sound banking policy.

Good Investing,

Jason Jenkins
iOnTheMarket Premium
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