Regulatory Effectiveness Essay Nicholas Penachio

Nick Penachio

Section 619 of the Dodd Frank Wall Street Reform and Consumer Protection also known as the Volker Rule is one of the most controversial pieces of regulation from the regulatory bill.  The rule is named after former Federal Reserve chairman Paul Volker. The Volker Rule puts strict rules on a number of investment bank functions. The most notable is effectively banning investment banks from engaging in short term proprietary trading. Proprietary trading is the trading of securities, bonds, derivatives, commodities, futures, options or other financial instruments by an organization with their own money on their own accounts for their own gain. This is made under the premise that proprietary trading does not benefit the bank’s customers and stockholders. The rule also enacts more compliance and guidelines over how banks trade financial instruments, regulation of investment bank’s investment in hedge funds and private equity funds, it also enacts compliance on bank’s ability to make risky investments.

Pre 2008 investments banks generated huge revenues from proprietary trading. The pretax profit from proprietary trading for the 8 biggest investment banks was over $10 billion. Pre 2008 proprietary traders were the rock stars of Wall Street.  Top proprietary traders such as Boaz Weinstein from Deustche Bank made over $70 million in bonuses in one year. Many of these investments that generated the banks enormous profits would have been considered “speculative” and “high risk”.

 The 2008 financial crisis had a very adverse effect on many investment bank’s proprietary trading desks. Many financial institutions invested heavily in collateralized debt obligations and mortgage back securities with their own money. These are financial instruments that are backed by people’s ability to pay back loans. However these investments where highly speculative, because they were backed by subprime mortgages, home mortgages that were made to people who would have a difficult time with repayment. The subprime mortgage crisis was caused by millions of people defaulting on their subprime home loans. Hundreds of small banks that issued these subprime mortgages went under. These defaults caused the value of mortgage backed securities fall significantly leading to big losses by investment banks. The subprime mortgage crisis was a major factor to the failure of several investment banks and the 2008 Financial Crisis. In the upheaval congress passed Dodd-Frank which heavily regulated the financial industry.

Large banks were engaging in very speculative proprietary trades for a very long time before the 2008 financial crisis. Many of these investment were in collateralized debt obligations and mortgage backed securities on subprime mortgages. The reason for the subprime mortgage crisis was most directly related to the Federal Reserve policies that allowed for easier lending by banks. Also to blame the small banks that issued subprime mortgages to people who were never go to repay their loans.

The Volcker Rule was made and passed during the uproar and anger at financial institutions after the 2008 financial crisis. When banks were paying billions of dollars of taxes on their proprietary trading revenues, the federal government was not trying to regulate banking activities. Going after proprietary trading was very short cited. It will cost banks millions if not billions for added compliance to go over trades. The Volcker Rule says the bank cannot engage in “risky” and “speculative” proprietary trading and investments. Aren’t almost all trades and investments “risky” or “speculative”? There should be more compliance on gaging specifically “risky” and “speculative” proprietary investments and trades.

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