Monday, April 26, 2010

Notes on the 'Volker Rule' and the Financial Crisis of 2008.

The ‘Volker Rule’, proposed by the Obama administration early in 2010, has generated considerable controversy. The two main features of the ‘Volker Rule’ is: 1) a ban on proprietary trading and bank involvement in hedge funds and private equity funds for their own profit independent of their customers, and 2) the introduction of measures to bar the further consolidation of the financial system. Much depends upon the exact wording of the planed legalization, but the ultimate aim is to rectify issues of moral hazard and to mitigate the systemic treat to the financial system posed by reckless financial operations. In terms of moral hazard, the proposed reforms will attempt to demarcate between speculative financial operations and commercial banking operations which are insured by the public. Therefore, according to the Administration’s position, undue risk will not be insured by the public and the costs of which will remain with those who have generated it, thereby reducing moral hazard. Concurrently, financial stability will be further served by the reduction of moral hazard and the interdiction placed upon increased consolidation of the financial system. In an effort to evaluate the proposed ‘Volker Rule’, an analysis of the financial crisis will be rendered, therefore allowing the White House’s position to be compared with prior experience of financial instability and the problem of moral hazard.

The proximal cause of the financial crisis was the increased rate of defaults among holders of sub-prime mortgages toward the end of 2006 and the beginning of 2007 (Blackburn, 2008, p. 64). The burst of the housing bubble and the free fall of mortgage-backed securities led to a classic liquidity trap. Bank increased their propensity to horde and ipso facto the credit market contracted. The underlying cause of the sub-prime market collapse, which precipitated the wider financial crisis, had deep roots within the evolution of the American financial system and the conditions of the consumption-led and debt-fed growth of the 2001-2006 period (Blackburn, 2008, p. 71; Gowan, 2009, pp. 7-9).

The growth exhibited in the 2001-2006 period was not predicated upon increased levels of productivity, evidenced by the enlarged levels of both corporate and private debt. Between 1997 and 2007 total debt in the U.S. economy grew by almost 100% of gross domestic product (GDP), from 255.3% in 1997 to 352.6% in 2007 (Blackburn, p. 66). Of this, debt in financial institutions grew the fastest with 63.8% of GDP in 1997 to 113.8 % of GDP in 2007, compared with an increase from 66.1% to 99.9% of GDP held by households in the same period (Blackburn, p. 66). This coalescence of debt within the American economy was itself a product of numerous factors, not least of which was the development of pension funds (injection of cheap credit) and the formation of what Peter Gowan (2009, pp. 6-8) has called the “New Wall Street System” that involved excessive levels of leveraging and a series of adjunct financial institutions that have been characterized as a “shadow banking system”.

The first plank of the Volker Rule, the proposed ban on proprietary trading in commercial banks and their involvement in hedge and private equity funds, is aimed at the shadow banking system. However, Paul Volker’s emphasis on commercial banking misses most of this system which is primarily based around investment banks. Senator Mike Johanns responded to Volker’s skewed focus upon commercial bank, he said: “I don’t think the Volcker rule would have stopped the behaviour of A.I.G.” (Chan, 2010). Volker dogged this counterfactual point by stating he wished to foresee future treats to the system and reaffirmed his commitment to end “taxpayer support for speculative activity” (Chan, 2010). The point still remains, however, that the financial crisis emanated from the highly leveraged position of investment banks and the shadowy system of associated financial institutions that facilitated balance-sheet expansion and ultimately debt saturation.

Of central importance to this picture, the shadow banking system was not only founded upon a new institutional framework (often referred to as the ‘lender-trader model’ and ‘prime brokerage model’) that linked traditional banks to hedge funds and private equity funds, but also the proliferation new financial product that dressed liabilities as assets (Gowan, 2009, p. 14). Credit derivatives, in the form of Collateralised Debt Obligations (CDOs) and Credit Default Swaps (CDSs), were two key financial products that caused much of the damage in the financial crisis (Blackburn, 2008, p. 75). Between 2001 and 2006, the total nominal value of sub-prime mortgages increased from $160 billion to $600 billion (Blackburn, 2008, p.72). Bank then bundled these loans into CDOs and sold them over the counter (OTC) to their clients without a market mechanism to determine the CDOs fundamental value. Rating agencies, who often underwrite CDOs for a free, would for a second fee rate these credit derivatives as ‘Triple A’, in terms of credit worthiness (Gowan, 2009, p. 14). The complexity of CDOs and the OTC nature of the transaction meant that they are extremely difficult to price effectively. This is because, unlike traditional commodity based derivatives, the notional value of mortgage tranches was not determinable as the components of any given CDOs were not known (Gowan, 2009, p. 15).

The proposed reforms entailed in the Volker Rule do not address the issue of credit derivatives and the effective pricing mechanism for such financial instruments, a process that fouled up the financial system with toxic assets. Nor does the Volker rule address the issue of leveraging within banking institutions. In fact, in 2004 the Securities and Exchange Commission agreed to effectively render “net capital rule” redundant, therefore allowing investment banks to determine their own debt/equity ratios (Gowan, 2009, p. 15). The thin capitalization that this allowed and the development of high-risk and complex financial instruments combined to cause extreme uncertainty within the financial system and therefore extreme instability. None of the Volker Rule recommendations rectify these underlying issues of financial instability. The attempt to demarcate between proprietary trading and commercial banking activities may decrease issues of moral hazard, depending upon the exact wording of the proposed legalization which remains unknown. The second stipulation of the Volker Rule, the ban on future consolidation of the banking system through a deposit cap, does nothing to address the already highly consolidated nature of the financial system and the spectre of ‘too big to fail’. In many respects, the Volker Rule is well intentioned but wholly inadequate in dealing with either the issue of moral hazard and financial instability.


Blackburn, R. (2008), “The Subprime Crisis”, New Left Review, 50, pp. 63-106.

Chan, Sewell. (2010), “Dodd Calls Obama Plan Too Grand”, New York Times, [], retrieved: 28th of March 2010.

Gowan, P. (2009), “Crisis In The Heartland: Consequences of the New Wall Street System”, New Left Review, 55, pp. 5-29.

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