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Compliance with risk targets – will the Volcker Rule be effective?

Four years ago, the Volcker Rule was codified as part of the Dodd–Frank Act in an attempt to separate allegedly risky trading activities from commercial banking. This column presents new evidence finding that those banks most affected by the Volcker Rule have indeed reduced their trading books much more than others. However, there are no corresponding effects on risk-taking – if anything, affected banks take more risks and use their trading accounts less for hedging.

Full compliance?

The Volcker Rule, passed as part of the Dodd–Frank Act in July 2010, has been appraised as one of the most important changes to banking regulation since the global financial crisis. By restricting banks’ business models and prohibiting allegedly risky activities, the rule ultimately aims at increasing resolvability and reducing imprudent risk-taking by banks, and therefore at increasing financial stability. This is done by banning banks from proprietary trading and limiting their investments in hedge funds and private equity. Four years after the enactment of Dodd–Frank and with the final rulemaking by regulatory agencies recently presented, it is time to evaluate whether the Volcker Rule has already had any major impact on the affected banks’ business models and risk-taking.

Although full compliance is not required before 2015, major affected bank holdings in the US have repeatedly announced reconfigurations of their business models. Apparently in an effort to comply with the Volcker Rule, these banks have declared that they have shut down proprietary trading desks and sold their shares in hedge funds.1

Despite those public compliance announcements, the effect of the Volcker Rule could be dubious. First, the final rules stipulate a long list of exemptions – for example, activities that might be seen as similar to proprietary trading or hedge fund investments, but are explicitly exempted from the ban. Second, as banks can take risks in many different ways (e.g. increasing leverage or risks in the trading or the banking book, or decreasing the hedging of the banking book), there is no reason to assume that a decrease in the size of the trading book or its particular activities decreases banks’ overall risk. Further, regulators may find it difficult to differentiate between prohibited and permitted activities such as trading on behalf of customers, market-making, or hedging. Hence, affected banks might be able to keep their risk targets without raising the leverage or the riskiness of their banking books.

Consequently, several authors have argued that the effect of the Volcker Rule on bank business models, overall bank risk, and financial stability might be rather limited. This might be a consequence of grey areas, creative compliance, reduced transparency, or simply other levers banks pull to keep their risk targets (see, e.g., Kroszner and Strahan 2011, Richardson et al. 2010, Chung and Keppo 2014).

What are the effects of the Volcker Rule to date?

Existing theoretical and empirical research cannot ultimately clarify the predicted effects of the Volcker Rule. First, papers evaluating the impact of the Volcker Rule are still relatively scarce (presumably because it is not yet fully implemented). Second, although numerous studies evaluate the historical precedents of the Volcker Rule – e.g. the Glass–Steagall Act – there is no clear consensus in the literature regarding the impact of a separation of commercial and investment banking on banks’ risk (Barth et al. 2000, Barth et al. 2004, Benston 1994, Saunders and Walter 1994, Stiroh 2006, Stiroh and Rumble 2006).

Motivated by the conflicting evidence, the work-in-progress implementation, and banks’ early compliance announcements, we analyse in a new working paper (Keppo and Korte 2014) whether and how banks are already complying with the rule and what the effects are of this compliance. For this, we construct a comprehensive dataset of all Bank Holding Companies (BHCs) in the US covering a timespan of ten years on a quarterly basis. We rely on the assumption that those BHCs that traditionally had their business models geared towards activities now banned or limited by the Volcker Rule (i.e. institutions with comparably large trading books and large non-bank investments) are affected most and should hence show the strongest reactions.

Trading books

To begin with, we find that banks – on average – reduce the size of their trading books relative to total assets after the passing of the Volcker Rule. This, of course, can only be traced back to the Volcker Rule by comparing the development over time and across groups of differently affected institutions. Indeed, we find that those BHCs that are presumably most affected by the Volcker Rule had even stronger reductions in their trading books, above and beyond the average effect. Moreover, when comparing affected banks and hedge funds, we do not find a similar trend – in fact, hedge fund assets have even been rising. The reduction of banks’ trading books is quite an intuitive reaction, and also corresponds with the public announcements by most of the banks that see themselves affected by the Volcker Rule.


Extending our model towards actual risk-taking by BHCs, however, we find less obvious results. While overall bank risk (expressed, for instance, in the composite measure of a bank’s distance to default) has decreased after the enactment of the Volcker Rule, we do not find a pronounced effect on the BHCs that are particularly affected. If anything, the risk reduction effect is smaller for the affected banks. Turning to the volatility of trading returns, we find those to be largely unchanged after the Volcker Rule; again, if anything, affected banks get more volatile trading books. The same applies to liquidity risk; if anything, affected banks hold less liquid assets. If the reduction of bank risk is an objective of the rule, our findings suggest that the Volcker Rule has so far not led to its intended consequences.

Nevertheless, there might be trading that is wanted and hence permitted as an exemption from the Volcker Rule. In fact, the Volcker Rule explicitly stipulates that trading accounts held for hedging purposes are permitted. If affected banks were increasingly using their trading accounts for hedging of banking book returns, we would expect the correlation between trading and banking returns to strongly decrease – or to be negative after the introduction of the Volcker Rule. We test for this and find neither to be the case. Rather, while the correlation between trading and banking returns has indeed decreased after the Volcker Rule became effective, the opposite is true for the most affected banks, which even experienced a significant increase in the correlation.


Taken together, our findings can be interpreted as evidence for successful risk targeting – although banks shifted portfolios to become at least more compliant with the Volcker Rule, they keep their risk targets (e.g. by hedging their banking businesses less). This explains why we find a significant decrease in the trading asset ratio, but no significant shift in overall risk. Further, possibly because of the continuing trading activities, the banking book risks have not, or at least not yet, risen significantly.

To be fair, the final regulatory rulebook for the Volcker Rule has only recently been published and it is not yet fully binding for banks. However, our results (together with several banks’ self-declared compliance) identify serious risks in the Volcker Rule. Since banks’ risk-taking incentives have not changed, the remaining assets in the trading book have been used less in the hedging of banking book returns. Thus, US regulators might want to analyse further possible implementation risks and unintended consequences to ensure increasing bank, and thereby, financial stability.

Our findings also have important implications for other regulators – those in the EU, for example – who are currently debating the introduction of similar separations between commercial banking and investment/trading business.


Barth, J R, R D Brumbaugh, and J A Wilcox (2000), “The Repeal of Glass–Steagall and the Advent of Broad Banking”, Journal of Economic Perspectives, 14(2): 191–204.

Barth, J R, G J Caprio, and R Levine (2004), “Bank Regulation and Supervision: What Works Best?”, Journal of Financial Intermediation, 13(2): 205–248.

Benston, G J (1994), “Universal Banking”, Journal of Economic Perspectives, 8(3): 121–143.

Chung, S and J Keppo (2014), “The Impact of Volcker Rule on Bank Profits and Default Probabilities”, Working paper.

Keppo, J and J Korte (2014), “Risk Targeting and Policy Illusions – Evidence from the Volcker Rule”, Working paper.

Kroszner, R S and P E Strahan (2011), “Financial regulatory reform: Challenges ahead”, American Economic Review, 101(3): 242–246.

Richardson, M, R C Smith, and I Walter (2010), “Large Banks and the Volcker Rule”, in V V Acharya, T F Cooley, M P Richardson, and I Walter (eds.), Regulating Wall Street: The Dodd–Frank Act and the New Architecture of Global Finance, John Wiley & Sons: 181–212.

Saunders, A and I Walter (1994), Universal Banking in the United States: What Could We Gain? What Could We Lose?, Oxford University Press.

Stiroh, K J (2006), “A portfolio view of banking with interest and noninterest activities”, Journal of Money, Credit and Banking, 38(5): 1351–1361.

Stiroh, K J and A Rumble (2006), “The dark side of diversification: The case of US Financial Holding Companies”, Journal of Banking & Finance, 30(8): 2131–2161.


1 See, e.g., Susanne Craig, “Goldman Moves to Comply With Volcker Rule”, New York Times, 10 May 2012; Lloyd Blankfein, “Goldman Sachs CEO Views the World From Wall Street”, Remarks at the Economic Club, 18 July 2012; Dakin Campbell and Jody Shenn, “Citigroup’s Raytcheva Survives Volcker Rule as Prop Trader”, Bloomberg, 25 June 2014.

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