Bank Proprietary Trading and Investment in Private Funds: Is the Volcker Rule a Panacea or Yet Another Maginot Line?

The Volcker Rule is part of the post-financial-crisis regulatory reforms that partly aim at addressing problems associated with proprietary trading by banking entities and the risks associated with the interconnectedness of private funds (e.g., hedge funds and private equity funds) with Large Complex Financial Institutions (LCFIs). This mission is pursued by introducing provisions that prohibit proprietary trading and banking entities’ investment in and sponsorship of private funds. These prohibitions have three specific objectives: addressing problems arising from the interconnectedness of private funds with LCFIs; preventing cross-subsidization of private funds by depository institutions having access to government explicit and implicit guarantees; and regulation of conflicts of interest in the relationship between banks, their customers, and private funds. Having studied the provisions of the Volcker Rule in light of its objectives, this article highlights the potential problems with the Rule and provides an early assessment as to how successful the Rule is in achieving its objectives. With respect to achieving these objectives, the Volcker Rule can only be partially successful for various reasons. The foremost reason is the numerous built-in exceptions (i.e., ‘permitted activities’) in the Rule included as a result of political compromises. Although the permitted activities under the Rule are backed by sound economic reasoning, there are serious practical problems with these exceptions. The main problem involves distinguishing prohibited activities from permitted activities. Such determinations require regulatory agencies to make subjective and case-by-case evaluations of activities. It is not known what the costs of such determinations would be in practice or how regulators would react if the costs of such determinations exceed their benefits. Regarding concerns about moral hazard, the Volcker Rule strikes a reasonable balance between preventing such an opportunistic behavior (i.e., taking advantage of government subsidies) while not stifling the investment by the banking industry in start-up private funds. However, with regard to mitigation of conflicts of interest, the Volcker Rule only marginally addresses such concerns. This limited regulatory intervention in mitigating conflicts of interest could be partially understood in light of the fact that market forces and private law have been successful in addressing conflict-of-interest concerns originating from the relationships between hedge funds and the banking industry