The Volcker Rule and its Consequences for the Banking System - Essay Example

The Volcker Rule and its Consequences for the Financial and Banking System Introduction The main purpose of Volcker Rule was to restrict banks from conducting risky activities which could possibly generate high amount of profits and losses (Liaw 2011). These restrictions were to be levied by not allowing banks to conduct certain kind of business transactions. If these measures are implemented they will have an adverse effect on the financial system of US and the businesses linked to it and the effect will not only effect US, but will even shake the financial systems of other nations linked to it. Federal Reserve has publicly announced that the banking system of US does not need to accept and operate according to the rule before the month of July of 2014 but the banks will have to conduct the process of “good faith planning efforts” to get ready to accept the rule in the future and during the temporary phase. As banks and the financial system is still not aware of the bans that will be levied, there will be a cloud of uncertainty that these systems will experience for two years (Ciro 2012). These systems are experiencing ambiguity in understanding what does the Federal Reserve means by good faith planning efforts. The ambiguities are making condition worse thus decision makers should make the scenario clear and present the effects of the rule on US and other nations. The cloudy situation was made clear when a draft of the regulation was prepared and this draft consisted of details regarding the services offered by financial system and the way these services are used by the common public. The situation is still quite unclear for financial institutions as even the draft wasn’t clear enough to identify the effects that the rule will have on financial sector. The European Union and other countries have even showed concerns as they expect that the rule will decrease the liquidity in world financial markets, thus it is quite clear that the rule will impact the financial systems negatively. Body The delay in implementing and clearing the effect of the rule may not help the banks and make situation worse as banks do not have the correct idea of when the rule will be implemented and banks will have to accept the rule legally regardless of whether they understand its effect or not. Legally it is stated that those banks that have operated in good faith effort during the temporary implementation phase will experience less problems in complying with the actual rule. The policy makers should make the scenario clearer instead of making the financial system of US and overseas operate according to their own guess work. The delay is making the financial system take decisions under ambiguous situation which is already hurting the system. Volcker Permitted Bank Activities According to the rule there are certain permitted activities that can be performed by the banks, these activities comprise of banks acting as market maker, underwriter, hedger, deals of government securities and other activities that are stated under the act as permitted activities. These activities have been permitted to ensure that banks continue to provide liquidity to the markets and help companies in raising capital. But these activities have been restricted to ensure that banks do not cross the line and the funds with the bank do not become unsafe. If the permitted activities cannot be conducted in a safe environment and without risky conditions, then the federal system has the right to barge banks from conducting such activities or increase charges and fines on these activities so these activities become unfavourable to the banks. The activities that have been stated as acceptable in the rule are done on the basis that the bank conducts these activities for the customer and only to meet the short term demands of the customers. Rule Effect The Volcker Rule has received its name from the Paul Volcker who was the Federal Reserve Chairman during the period of the financial crises of 2008. The entire rule was designed and created by the chairman, according to this rule, banks were supposed to be restricted from conducting trading in equity funds of private companies, hedge funds and from conducting proprietary trading such as buying and selling of stocks and bonds. When banks are involved in trading of private equity funds, they are basically investing in new firms and businesses that are smaller in size and the bank earns by obtaining interest for their investment. When a bank is involved in proprietary trading, they do not conduct business on behalf of customers, they rather conduct business for their own profit. These prohibitions are only to be exercised by banks and not by other organizations that are counted as financial institution even including financial institutions that are recognized by the Financial Stability Oversight Council as too huge to fail. The reasons due to which the rule wants to prohibits such kind of trading activities conducted by banks is that the banks will continue investing in such risky activities as if they are gambling and they will have no or low fear of losses as they are insured by the FDIC. Those who stood behind supporting the rule believe that if banks are not restricted, they will continue investing huge amount of money without fearing losses and earning huge profits which will increase their bonuses and profitability and if they fail they will be aided by the money paid by the tax payers. This means that banks will have no fear of loss and they will keep their eyes only on the profits that can be obtained through such trading activities. Thos who supported the rule have failed to completely understand the effect that the rule will have on the banks. They have especially failed to understand how proprietary trading works. It is clearly evident that the supporters have failed to distinguish between transactions that are done by bank for the customer and the transactions they perform for themselves. The draft of the main regulation have referred to proprietary trading as short term but they have failed to clearly define what they really mean by short-term. The ambiguous situation faced by banks is that whether they are trading against the rule or are in compliance if the banks purchase a certain instrument for the client with the expectation of getting higher returns in the future or to provide a client with that particular instrument (Anand 2011). The ambiguity of the scenario even elevates when a bank acts as a market maker for any particular security. A bank is recognized as a market marker when the bank indulges itself in the activities of selling and buying a particular security so other investors gain confidence in that particular security and they even invest in the security. In short, when a bank becomes Market Maker they become liable to hold certain percentage of a security’s inventory. This operation by the bank helps the business obtains capital so it can continue operations and conduct business (Chow 2011). A Market Maker trades in various instruments of finance such as stocks, bonds and foreign exchange. The rule barges a bank from involving in activities regarded as market making which is feared not only by US, but even by overseas financial systems as banks investment in such activities helps provide liquidity to perform business activities. Conclusion This rule will not bring any advancement to the banking system; instead it will push the banking system of US to the banking system followed by US about fifty years ago. The 50 years back banking system followed in the US was quite similar to the Volcker Rule. During that period banks were not allowed to invest in products which are restricted by the rule. Though, during this period, other financial institutions of the financial system of US created financial instruments and products that help them grow. Thus, banks failed to attract customers who were less risky and these customers borrowed from other financial institution. While on the other hand, banks were only left with the ability supply its services to risky borrowers, this incident changed the scenario of the US banking system during 1999. Similarly, the Volcker rule is not a well thought product of the policy makers, it is destined to only harm the banking system and the banking system will lose its customers and business which will make the US banks much more risky than ever. The rule of restricting banks for trading in private equity funds and proprietor trading is assumed to create shortage of capital for businesses that raise capital through different financial instruments such as stock and bonds. This will not help the current financial situation of US and will instead push the banks into further financial turmoil. The Congress and the policy makers have to take strict measures as soon as possible, because the rule is already creating havoc within the banking sector and will continue to create disturbances for the banks as long as the uncertainties of the Volcker rule prevails. Works Cited Liaw, K T. The Business of Investment Banking: A Comprehensive Overview. Hoboken, N.J: Wiley, 2011. Print. This source was used to obtain information regarding the main purposes of the Volcker Rule, the purpose identified were: to increase the accountability of the banking system and to counter the way banks have been playing with risk and to help US economy gain financial stability and save tax payers funds. Ciro, Tony. The Global Financial Crisis: Triggers, Responses and Aftermath. Farnham, Surrey: Ashgate Pub, 2012. Print This source was used to obtain information about the current effects of the Volcker Rule, the current effects includes the ambiguities that have clouded the banking system of US and overseas. Due to the ambiguity of final implementation date, the US banking sector has been left to guess and make decisions according to their guest. Anand, Sanjay. Essentials of the Dodd-Frank Act. Hoboken, New Jersey: Wiley, 2011. Print. This source was used to obtain information about the bans that the Rule is going to levy on the US banking system and how are these bans going to negatively impact the US banking system and cause the problem of liquidity. Chow, Julian T. S, and Jay Surti. Making Banks Safer: Can Volcker and Vickers Do It?Washington, D.C.: International Monetary Fund, 2011. Internet resource. This source was used to obtain information about how the Rule will negatively affect the banks operation of market making. Read More