The Economic Consequences of the Volcker Rule

EXECUTIVE SUMMARY

This paper provides a fairly extensive analysis of the potential economic consequences of the Volcker Rule, which is a part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). This rule puts restrictions on banks’ ability to engage in private equity and hedge fund activities and to engage in proprietary trading, some of which may even be related to market making activities. The analysis reveals that these restrictions will adversely affect bank customers as well as banks.

First, the Volcker Rule will have a negative effect on market making and liquidity provision for many securities. The Volcker Rule will induce banks to retrench more from market making in smaller and riskier securities where large and unexpected supply-demand shocks are more likely, thereby reducing market making in the very securities where it is most valuable. The securities issuers and the investors will feel the effects.

There will also be other adverse consequences for bank customers. They will experience a lowered value of financial services provided by banks, less liquidity for the securities that banks issue, and more distorted prices of bank securities that remain distorted for longer than before. Moreover, bank customers are also likely to be forced to record mark-tomarket losses on the securities that they hold.

Second, the Volcker Rule will reduce the network benefits of market making for financial institutions and businesses. Market makers in securities operate in networks, and the retrenchment of banks in market making will reduce the value of the network even if unregulated (non-bank) entities move in to fill the vacuum created by the exit of banks. This will eventually hurt bank customers.

Third, the Volcker Rule is likely to lead to higher costs of capital for businesses and potentially lower capital investments by these borrowers, along with a possibly greater focus on riskier or more short-termoriented investments. Due to reduced liquidity and greater perceived regulatory uncertainty, borrowers will be confronted with higher costs of capital. This is likely to reduce aggregate investment and also make riskier investments more attractive. Moreover, firms will find it more attractive to invest in projects that pay off faster. The reduction in aggregate capital investment may also cause significant job losses.