The Volker Rule is a regulation that was made by the federal government targeting banks. The
law prohibits banks from undertaking certain investment activities while using their accounts and
also from limiting their dealings with private equity funds and hedge funds. The purpose of the
regulation was to protect bank customers by ensuring that banks don’t make or rather engage in
speculative investments, which could lead to the financial crisis that was recorded in 2008. 1
Under the rules, Banks are prohibited from using their accounts to engage in short-term
proprietary trading of commodity futures, derivatives, and securities. Banks are further
prohibited from retaining or acquiring ownership interests in private equity funds or hedge funds.
In other words, it can be said that the rule seeks to discourage banks from engaging in too many
risks, which would make them use their funds to make those kinds of risks that were envisioned
or instead highlighted on the regulation. In as much the investment would yield so much profit
for the organization, the risks involved were too high and the customers would highly be
disadvantaged if things do not go as planned for the bank.
It is essential to have a look at the historical perspective of the rule to understand the economic
effects that the rule regulation had on banks and how customers were protected in general..
The Securities Act of 1933 and the Glass-Steagall Act were enacted during the reign of President
Franklin Roosevelt. The purpose of the Glass-Steagall Act was to regulate the banking sector by
ensuring that there was the separation of commercial banking from investment banking. 2 The
1 H. S. Shin and Adrian, T., “Liquidity and Leverage,” working paper, Federal Reserve Bank of New York
Staff Report 328, June 2007.
purpose of the act was to create a distinct banking system of the United States which could be
distinguished from other banks across Europe. One of the unique features of the Glass-Steagall
act was that it was able to ensure that the banking industry in the United States were provided
with federal deposit insurance. The purpose of the insurance was to protect banks from capital
risks which would emerge from taking part in non-banking activities. The federal deposit
insurance created a contingency fund that was going to protect taxpayers in the United States
from any liability that may arise from the activities of the bank.
The Glass-Steagall was successful in maintaining sanity within the Banking Industry in the
United States. Under the act, banks were allowed to issue loans but not guarantee securities,
although investment banks were allowed to guarantee securities. From 1980s-1990s, there was
the emergence of securitization, which was a force within the banking sector. Securitization was
the process that involved the pooling of illiquid assets such as mortgages in a portfolio where
they kept in trust; claims were placed on the collection which was sold on the capital market
The emergence of the securitization was considered as a landmark financial innovation. This is
because it allowed banks to diversify their operations and to proliferate. The banks in the United
States were able to venture into various sectors of the economy; they begun purchasing claims
against loans from other banks, and sold some of their loans to other banks. With the rise in the
application of securitization, there was the inability to demystify the boundary between securities
and loans. As a result of the banks diversifying their activities, they began facing a financial
crisis that affected the customers.
2 Kimberly D. Krawiec & Guangya Liu. “The Volcker Rule: A Brief Political History” Capital Markets Law Journal
As a result of consumers being exposed, it was necessary to protect them. The act was the work
of former economist Paul Volcker who came up with the regulation that was going to handle the
financial crisis in which banks were majorly affected. Big banks that were operating within the
United States were recording huge losses. The regulation aimed to separate the commercial part
of the bank and investment part of the bank, this division was an insistence, but it had been
dissolved by the Glass-Steagall Act.
This is just a short review of the impact that the Volcker-Rule had on the government’s role in
creating an enabling environment, how customers were protected and how the banks were
affected as a result of the law coming into operation.
The effect of the Volcker Rule on the market and its liquidity
In analyzing the impact that this rule had on the market, it will be essential in observing the
impact that the company has had on the economy. The analysis shall be done in three parts that
are the economies of the market and liquidity provision, network effect in the market, and the
impact that the rule has had on the market making.
Economics of Market Making and Liquidity Provision
The role of market makers in an economy cannot be downplayed, and this is because they play a
crucial role in security markets and proprietary trading. Most of the government bonds, corporate
bonds, and municipal bonds have, in most instances, been managed by the market markers.
Market makers play an essential role in ensuring that it is liquidity in the security market. Banks
played this role effectively before the Volcker Rule. 3 For instance, when an investor wanted to
sell their security, they would call a reliable bank that acted as a market maker, the bank would
3 Oonagh McDonald “The Repeal of the Glass-Steagall Act” Policy Analysis (2016)
then purchase the securities using their money, and the guards are then converted to become
inventories of the bank. This kind of transaction had an economic value, and this is because the
buyer cannot wait for long until a buyer avails himself or herself to purchase their security;
therefore, there was an expeditious transaction.
On the other hand, the market maker had increased the liquidity of the bank in the economy. This
is because the securities could be sold in the absence of the moving price that is against it. The
bank, in this instance, helped to eliminate the issue or rather the case of brokers in the market.
Therefore, they were able to reduce the imbalance of supply and demand that would have
occurred in the market.
With the Volcker rules coming to force, the banks cannot engage in proprietary trading as there
were stringent measures that have been placed by the rules. The measures to be adhered to
include that the underwriting activity that the company wishes to take in should not go beyond
reasonably expected terms demanded by the customer, clients, or counterparts. The restrictions
that were placed by the Volcker rule have limited the inventory holding of underwriters; this has,
therefore, compromised the ability of the underwriters to ensure that liquidity is maintained
within the market. Most of the municipal securities have also not been able to trade as they did
not qualify as provided for under the law; therefore, it was essential to have an amendment on
the municipal bond being undertaken to make sure that they can trade within the provisions of
the Volcker rules.
Therefore, the ability of the market maker to engross supply and demand imbalances to gain
compensation that offered economic benefits for the company. It can, thus, be summarized that
the role that banks played in reducing the chain without involving brokers has been curtailed by
the act. This has further reduced the liquidity of inventories that were being maintained by the
large banks. Although it will be worthy to not that banks have stayed on their main course of
providing banking services to customers.
Network Impact in Market Making
Bech and Garratt (2003) had observed that the maker could not operate in a vacuum; therefore,
the environment within the securities needs to be conducive for the market marker to engage
ineffectively. 4 The role that the market makers play in an economy is the ability to take or
participate in opportunities that allow it to engage in trade with other market makers. This was an
excellent engagement as the various market makers had a vast knowledge of the market and how
many orders that the customers have. Therefore, the existence of the market markers has been
able to enlarge the capacity of a specific market marker to enable imminence.
The network had proven to be crucial in understanding the security market. With the introduction
of the Volcker Rule, it has affected how the system that was enjoyed by the market markers has
been disrupted. 5 The exit of the banks in the market is credited to have caused this problem, in as
much as other have rushed to fill the void that was left by the banks, the process remains not to
be the same. The banks were now able to focus on their main agenda of providing financial
services to clients.
Effect of the Volcker Rule on Market Making.
4 Morten L. Bech and Rodney J. Garratt, lliquidity in the Interbank Payment System Following Wide-Scale
Disruptions. Journal of Money, Credit and Banking (2012)
5 Morten L. Bech, Intraday Liquidity Management: A tale of Games Banks Play. Journal of Economic Review
When banks were frozen up from taking part in market making, the consequences were either
anticipated or they were overlooked. For instance, credit ratings were affected; this had an effect
on the market as parties could not freely engage banks for loans; this is because there was an
increased legal liability for ratings. Therefore, borrowers were not able to obtain the ratings;
consequently, they could not engage in debt securities. The reduction of debt securities
providedbanks with the need of critically evaluating their loans.
Effect of the Volcker Rule on Businesses.
Based on the foregoing, it can be stated that the application of the Volcker rule affected various
sectors of the economy, that is, the borrowers, the banks, and those that are selling their
securities. This has affected not only the market markers but also specific stakeholders, and this
section is going to evaluate the impact that the Volcker rule has had on business.
The firm implementation of this rule has not only adversely affected banks but also their
customers, and this section shall address how customers have been affected by this rule. The
figure below summarizes.
The role that was initially played by market markers was to increase liquidity by absorbing
demand and supply shocks. With the regulations, banks who acted as market makers were
Higher Cost of
Potentially Lower and
Effects on Customers
limited in taking part in the purchase of securities and including them to parts of their inventory.
When the market makers were in the picture, the prices of the traders were slightly less. Further,
with their absence in the market, it was certain that it would take a more extended period before
the prices of the securities will be affected. 6
Therefore, the Volcker rule was able to affect the liquidity of the market in the following
1. The bid-ask spread; and
2. The responsive price to order flow.
The impact of reduced liquidity on the firms was that the price of the assets of the company is
likely to be affected. The effect is now being felt by the consumer because, those that want to
engage in the capital market of the U.S, they will have to incur the cost of the transaction.
The price of security depends on the cash flow with the existing or rather the reduced presence of
banks in the securities market; the cash flow seems to be reduced. The impact of the banks in the
market was that there was more liquidity, with the exit of banks; it means that there will be
reduced liquidity in the market. The impact of this has been that there has been a drop in the
prices in the market. This has resulted into lowering the liquidity in the market; thereby causing
losses to the investors. The magnitude of this has been too much that investors have been aware
of the magnitude of the losses and are now aware of the impact that the Volcker Rule has had on
6 Anjan V. Thakor & John E. Simon, The economic consequences of the Volcker Rule. Center for Capital Markets
Distorted Security Price
The liquidity of the market has an impact on the price of the security in the market. When the
price drastically reduces, then the price of securities will be distorted. The effect of the Volcker
Rule has changed the market price as the security prices have greatly been affected. With the exit
of banks in the securities market, the brokerage system has found itself in the market. 7 The
impact of the Volcker rule has been that there is competitiveness when it comes to price as the
financial power that was presented by banks has been eliminated.
Impact that the Volcker Rule brough to Financial Institutions
The Volcker rule had an impact on risk management conducted by banks. The operation of banks
is coupled up with many risks, with the coming into force of the Volcker rules it has made it
somehow challenging for banks to manage or mitigate their risks. Some of the risks that banks
face include; interest rate risks, credit risk, and liquidity risks.
Securitization had been considered as the best method or rather mechanism in which banks
would be able to mitigate credit risks. Banks had concentrated in focusing their loan activities in
other sectors where credit screening was used; here, banks were able to identify bad credits,
thereby mitigating the credit risk that would have emerged. Securitization, therefore, offered
banks an opportunity to reduce the concentration of their credit as the loans could be sold off to
other banks and non-banking investors.
Banks were further able to improve their interest rate risk; this is because securitization created
tranches with various maturities. The mitigation of the interest risk was through purchasing loans
7 John C. Coates IV, The Volcker Rule as Structrual Law: Implications for Cost-Benefit Analysis and
Administtative Law. Harvard Law Journal (2015)
that were pooled together, and they were securitized. 8 The main source of the interest rate of
banks was that their loans had longer maturity dates compared with their deposits. The maturity
disparity implies banks are going to make losses when the interest rates rise. The banks used to
purchase assets that were backed with securities, and they had a short maturity date compared to
the average period of the loan from which it emerged.
Banks were also able to mitigate their liquidity risk through securitization. Banks were
securitizing their illiquid loans; therefore, they were able to create a portfolio of liquid claims
which were traded in the capital market. Through securitization, banks were able to mitigate the
three significant risks that they were exposed to.
The effect that the Volcker rule had on banks was that they could not mitigate the operational
risks that they were exposed to. This, therefore, subjected many banks to the risks, some banks
were unable to overcome the risks, and as a result, they went under. Banks that still hold on
securitized inventory loans are required to justify to the regulators they are maintaining the
inventories, not for proprietary trading.
Quality of Loans
Banks do not have sufficient resource to screen a loan application; therefore due diligence was
not that effective when it comes to screening of loans because the loans were going to be
securitized, although banks have made sure that loans that will not be securitized are well
scrutinized, this is because the loans will stay long in their books. This has had the banks avoid
loans that are somehow considered to be bad loans, therefore, some loans applications are made
by customers in specific instances are denied. Therefore, banks are not actively issuing loans as
they used to, but now, they are carefully evaluating the loan applications because those loans
cannot be sold. Banks are therefore focusing on approving loans that are risk-free because they
will incur the loss in the event the loan is not settled.
Reduced Financial value services rendered by Banks
Before coming to force of the Volcker Rule, banks were offering a variety of services to their
customers. With the regulations coming into force, it has reduced some functions that were being
rendered by the banks. For instance, banks used to act as market makers, but his role has been
affected by the regulations that are earlier discussed. Some services are not actively being
rendered by banks; these services were widely referred to as “advisory services.” Examples of
such advisory services include mergers and acquisitions, security sales and trading, investment
management, and raising capital.
Restructuring made by Financial Institutions.
Banks have had to restructure their operations so that they can conform to the new demands of
the regulations. The banks had to diversify their operations to include commercial services and
investment banking, such as market-making and securities underwriting. The banks had
diversified there operations so that they could be able to expand their business activities, and
they remain relevant in the market. 9 Below are some of the steps that were undertaken by the
banks to make sure that they were able to run their business effectively:
1. Exploiting liquidity- banks have tried as much as they can to ensure that they maintain
liquid assets on their balance sheets; this will enable them to be able to manage their
9 Meraj Allahrakha, Jill Cetina, Sumundu Watugala & Benjamin Munyan, The Effects of the Volcker Rule on
CorporateBond Trading: Evidence from the UnderwritingExemption..Office of Financial Research (2019)
liquidity risk. Although this is a challenge to certain banks, this is because liquid assets
like cash are considered to be “lazy” assets from which banks earn little return.
2. Using Capital Effectively- capital has the effect of affecting the ability of banks to
participate in the tradeoff. Banks had to restructure their capital to make sure that they
can cushion any turbulence that they may face when they are running their business. With
proper utilization of the capital, it means that the banks will be able to address any
financial distress that they may be faced within the process of running their business.
3. Improved service delivery to customers- banks have diversified their financial services to
be able to gather sufficient information about the market. This has made banks to attract
customers compared to banks that are not engaged in diversified financial services.
In as much as the Volcker rule intention was to regulate banks and protect customers of banks .
The regulation has adversely affected banks and also customers, as the extra revenue generation
activity that was being undertaken by banks was sealed. Therefore, banks were faced with a
challenge in their operation as they could not effectively manage their risks. This has forced
banks to try other diversification methods that will make it possible for the banks to mitigate
their risks. Even though the regulations achieved in protecting customers, the stringent nature of
the rules have made it possible to steamline the operations of the banks. There is no need of
amending the law as banks have worked around the regulation to find their stbilty and also
continued to offer financial services to the people.