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Here's how the Volcker Rule protects banking customers.

The Volcker Rule was established after the Great Recession and financial crisis that took place between 2007 and 2009. Thanks to timely intervention by both the Bush and Obama administrations, the Great Recession stopped short of spiraling into an all-out second Great Depression. However, the consequences still made a big impact. As a result, economists proposed rules to help keep it from happening again. One of those reforms, packaged into the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, was the Volcker Rule.

Here’s a breakdown of what the Volcker Rule is and how it protects banking customers.

What Is the Volcker Rule?

Formally known as Section 619 of the Dodd-Frank Act, this reform was renamed after the former Federal Reserve chairman who first proposed it: Paul Volcker.

The Volcker Rule places strict limits on federally insured depository banks from investing in stocks and other securities with the bank’s own money (known as proprietary trading). It also bans these institutions from ownership in hedge and private equity funds. The Volcker Rule extends to any subsidiary or affiliate of the bank, as well. Banks have been required to comply with the rule since July 21, 2015.

How Does It Protect Banking Consumers?

The Volcker Rule helps keep banks from making speculative investments that expose their customers to risk. Congress enacted similar reforms in the wake of the Great Depression to help protect consumer deposits.

To understand how the Volcker Rule works exactly, it’s wise to understand the system that Congress created in 1933 with the Glass-Steagall Act. The Glass-Steagall Act was passed as part of the Banking Act of 1933. It separated banks into two forms: depository and investment institutions.

An investment bank can use its funds to trade securities and otherwise expose itself to speculative investments. These banks are not allowed to take deposits, open up checking or savings accounts, or otherwise operate like a commercial bank.

A depository institution conducts all of the retail operations we associate with banking. Most notably, they can accept deposits from consumers and give an interest rate in return. The FDIC insures depository banks. This means that if something goes wrong and the bank goes out of business, every penny held for consumers will be reimbursed up to $250,000 per account.

However, depository institutions have very strict rules on how they can invest in securities and other properties. In theory they can only make their money by investing in traditional, secured assets, like mortgages and car loans. This is because the bank makes those investments with its depositors’ money and the government doesn’t want the bank taking on excessive risk. At the same time, the government wants to minimize the risk of a depository institution going bankrupt.

The Volcker Rule helps ensure that insured depository institutions or any company affiliated with one doesn’t engage in proprietary trading. This helps protect consumers from losing money. After the financial crisis in 2008, Lehman Brothers evaporated after a series of bad bets. The Volcker Rule helps prevent the same thing from happening with insured depository institutions.

Proprietary Trading

Here's how the Volcker Rule protects banking customers.

Since 1933, there have been strict laws around a depository bank using consumers’ money to buy stocks, commodities and other speculative securities. However, deregulation in the 1980s and 1990s made it easier for them to re-enter the market in other ways; most notably by investing with the banks own accounts, money taken from profits rather than deposits. During the Great Recession, even depository banks suffered enormous losses from these loosened restrictions as products, most notably mortgage-backed securities, crashed in value.

The idea behind the Volcker Rule is that this creates too much risk to the consumer market.

Even if a bank doesn’t directly use its depositors’ money to make these investments, the bank still exposes its customers to risk by putting its own solvency on the line. A bank that makes poor investments with its own money could lose more than it can afford. It could also end up in debt. This risks not only insolvency but potential embezzlement, as bankers would be encouraged to use money on deposit to settle the institution’s accounts.

The Volcker Rule puts strict guard rails around this practice. If a bank accepts federal insurance through the FDIC, it cannot engage in speculative trading even with its own money.

Exceptions and Controversy

The Volcker Rule bans proprietary trading, and hedge funds and private equity funds for consumer banks. However, it does have a few exceptions. The most important two are market making and hedging risk.

Market Making

A depository bank can help consumers find people with whom to trade securities. It can act as the middleman, connecting buyers and sellers for a commission.

For example, if one Bank A has a client who wants to liquidate oil futures, Bank A may participate in that market for the purpose of helping that client sell its securities. In this case, Bank A would be “making a market” for its client’s oil futures.

Hedging Risk

A depository bank can also participate in securities and speculation to offset the risk of existing, legitimate business. The most classic example of this is currency trading against loans.

Say Bank A has a customer that took out a large loan in euros. Now suppose it anticipates that the value of the euro against the U.S. dollar will fall. In this case, Bank A (which reports its profits and pays its taxes in U.S. dollars) is about to take a significant loss.

Bank A could go into the FOREX markets and purchase short-sale options on the euro. This would pay Bank A profits if the euro falls against the U.S. dollar. Ordinarily, this would be precisely the sort of high-risk speculation in which depository banks shouldn’t engage. However, in this case, Bank A would be doing it to hedge against risk. If the euro does, in fact, lose value, the bank will offset its losses on the loan through its gain on the options.

Much of the rule’s controversy comes from these two activities. Bankers have long argued that the Volcker Rule does too little to clarify what counts as hedging risk or market making vs. inappropriate speculation. They also argue that the rule is too restrictive for them to effectively do either. Since the rule was implemented, Treasury officials have proposed changes to the Dodd-Frank Act and the Volcker Rule.

The Bottom Line

Here's how the Volcker Rule protects banking customers.

While investment banks can play a critical role in capitalizing on new and existing enterprises, depository banks were never supposed to be high-flying financial machines. They were meant to cut mortgages, give reasonable interest rates and help you buy a Treasury bond (if you were feeling frisky). And this model generally works. A depository bank does not need to invest in speculative, exotic and high-return products in order to extend small business loans. However, this model also would be unrecognizable compared to the balance sheets of a modern consumer banks today.

In exchange for seeking greater profits, depository banks have exposed themselves – and their customers – to greater risks. The Volcker Rule protects you by limiting the kind of risks that your banker can take. This makes it less likely that your bank will make bad bets, leading to losses, insolvency and (at the outside edge) embezzlement. It isn’t always pretty or perfect, but it’s a considerable improvement after the Great Recession.

Tips for Banking Customers

  • If you’re unsure of the best bank for your financial situation, consider working with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • The interest rate on your savings account can make a big difference in growing your money over time. Use a savings calculator to see how much money you could have in five, 10 or 15 years. With the right savings strategy, you’ll be on your way to achieving your financial goals.

Photo credit: ©iStock.com/busracavus, ©iStock.com/g-stockstudio, ©iStock.com/seb_ra

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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