Systemic Risk and Dodd-Frank\u27s Volcker Rule

With the recent global financial crisis starting in 2007, the issue of “systemic risk” has attracted much attention in our financial system. Some legislators have asserted that proprietary trading by banking entities, generally the trading of financial instruments for a banking entity’s own account, played a critical role in the recent global financial crisis. These sentiments parallel arguments that the practices of banks and their securities affiliates in the 1920s were partly responsible for the stock market crash of 1929 and subsequent Great Depression. At the heart of these assertions is the issue of whether combining the businesses of commercial banking and investment banking increases systemic risk. The Banking Act of 1933 (Glass-Steagall Act) contains provisions that prohibit commercial banks from underwriting, promoting, or selling securities directly or through an affiliated brokerage firm, effectively erecting a wall between commercial banking and investment banking. That wall was gradually weakened and picked apart over the course of the next sixty years or so, finally coming down with the Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act), which repealed the last remaining restrictions of the Glass-Steagall Act’s wall. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of 2010 makes the most sweeping regulatory changes in this area since the 1930s by re-erecting portions of Glass-Steagall’s wall. The Volcker rule, contained in the Dodd-Frank Act, restricts “banking entities” from engaging in proprietary trading, and from sponsoring, or acquiring or retaining certain ownership interests in, a hedge or private equity fund. One of the policy justifications for these restrictions is that the prohibited activities increase systemic risk. The implicit contentions in this justification are that if the prohibited activities are too risky they could affect a bank’s liquidity, causing the banking entity to (i) be unwilling or unable to extend credit to qualified borrowers or (ii) to fail, disrupting credit channels. Similarly, some fear that banking entities may also fail from exposure to failing hedge or private equity funds, further disrupting credit channels. Are these implicit contentions underlying the Volcker rule’s enactment with respect to the policy rationale of systemic risk well founded? One way to attempt to answer that question is to look at whether the blending of commercial and investment banking really played a critical role in the recent recession and in the Great Depression, as some proponents of the Volcker rule and the Glass-Steagall Act contend. Parts I and II of this Article will provide the background necessary for a discussion of these questions. Part I will discuss the concept of systemic risk in general and describe the Volcker rule and its origins. Part II will describe the history of systemic risk banking regulation in the United States. Part III of this Article asks the important question of whether the blending of commercial banking and investment banking produces the alleged harm: increased systemic risk. The Article considers the argument that blending played a role in the stock market crash of 1929. It also considers the argument that blending played a role in the financial crisis of 2007. Part III concludes that the claims that the walls contained in the Glass-Steagall Act and Volcker rule are needed to decrease systemic risk have not been necessarily proven or statistically supported. It seems that the Glass-Steagall wall was erected in 1933 to address conflicts of interest in the blending and to serve as a purported fix to the horrors of the Great Depression in the name of regulating systemic risk—a wall erected for more political than economic reasons in satisfying public outcry to do something, anything, about the disaster. Eugene White’s bank failure statistics demonstrate not only that the blending may not increase systemic risk but that there may be diversification, complementaries, and economies of scope benefits to the blending. The policy justifications of the Glass-Steagall and Volcker rule walls must be detangled. If the conflicts of interest are the main harm we are trying to address, it may make sense to consider other solutions such as additional disclosures and regulations that protect the public from such conflicts. If, however, the harm we are trying to address is truly systemic risk, this Article posits that we need a better understanding of systemic risk in a modern era of financial innovation before we erect the Volcker rule wall that may decrease economies of scope, diversification of risks and perhaps even global competitiveness. Perhaps doing something must wait for a better understanding of systemic risk and excessive risk-taking with respect to today’s financial innovation and instruments. Once there, the Article posits that there must be some balancing of the synergies and global economic advantages created from the blending and systemic risk concerns