The Volcker Rule and Potential Conflicts of Interests in Banks

Under intense pressure from the banking industry, the Trump Administration recently introduced legislation to repeal the Dodd-Frank Act and thereby eliminate the Volcker Rule. This development immediately raises the question of why the big banks would want to worry about a small, arcane, technical trading rule such as the Volcker Rule. The answer is that the Volcker Rule, if properly implemented, would eliminate huge amount of profits banks are currently making from proprietary stock trading that may be in conflict with their clients’ interests.

Information, especially material, asymmetric, non-public kind is the key to making money in the market. Other issues such as fairness, ethics, or conflicts don’t matter as much. Banks come by material, non-public information about their client firms when they are hired as advisers and consultants. Suppose a client firm is experiencing financial difficulties and hires a big bank to help advise it to deal with its problems. So, now the bank also knows all the specifics about the firm’s financial problems. What should the bank do with this information? The one thing we would not want the bank to do is to trade on this information for its own proprietary purposes by selling the firm’s stock. The reasons for this are obvious. First, the information belongs to the client firm not to the bank. Second, selling the firms stock publicly can potentially alert the entire world (including the firm’s employees, customers, suppliers and competitors) to the firm’s problems and make it more difficult to deal with these problems. Thus, trading on this information creates a conflict of interest between the bank and its client firm. It is exactly for this reason that Volcker Rule was passed to eliminate the potential conflicts of interest between the banks and their client firms.

The original motivation for the Glass-Steagall Act, which completely separated commercial banking from investment banking and prohibited banks from underwriting new securities, was in part to control these potential conflicts, specifically to prevent banks from using the material, non-public, adverse information they acquire from the normal banking activities in trading or underwriting new securities. For instance, if banks realize that a particular client is in danger of financial distress, they would also have an incentive to arrange for a new security sale to the public and use the proceeds of those sales to pay off the bank loans.

The gradual weakening and subsequent repeal of most provisions of the Glass-Steagall Act in 1999 allowed commercial banks to acquire investment banking subsidiaries, to grow substantially in size, and to access even more information through more diverse banking activities. [1] At the same time, proprietary trading became a major source of revenue for the banks. [2] To prevent potential conflicts of interests that came from proprietary trading while acquiring material, non-public information about their clients, the SEC required so-called Chinese Walls, which refers to complete separation of personnel, decision-making and compensation between investment banking and commercial banking.

The subsequent financial crisis of 2008 exposed another glaring weakness of banking in the post-Glass-Steagall era. Banks had grown too big, too risky and too interconnected, many surpassing trillions of dollars in assets, interbank loans and liabilities on and off balance sheet. The sheer size, risk and interconnectedness of banking alone raised concerns about systemically important and too-big-to-fail banks. After numerous attempts to bring back Glass-Steagall failed, Congress attempted to contain banking systemic banking risk by passing the Volcker rule to prohibit proprietary trading, and enacting consumer protection and other ring-fencing and fire-wall provisions in the Dodd-Frank Act. [3] The stated purpose of the Volcker Rule is as follows:

1. to reduce risks to the financial system by limiting the ability of banks to engage in activities other than socially valuable core banking activities;
2. to protect taxpayers and reduce moral hazard by removing explicit and implicit government guarantees for high-risk activities outside of the core business of banking; and
3. to eliminate any conflict of interest that arises from banks engaging in activities from which their profits are earned at the expense of their customers or clients. [4]

How important are these potential conflicts in banks? To test the potential importance of the Volcker Rule in preventing such conflicts, we would need to know the amount of profits banks make from using proprietary adverse information about their clients. However, the source of the proprietary information banks use to execute their proprietary trading programs is typically confidential. Furthermore, banks do not disclose where and how they obtain this confidential information, which helps them create billions of dollars of profits every year.

In a forthcoming article we investigate one possible source of this information. Specifically, we investigate the importance of the private information banks acquire as part of their financial intermediary and financial advisory role for their client firms. Banks often attain insider trading status and become subject to insider trading reporting requirements and trading restrictions when they are hired to provide financial advice to their client firms. When banks become temporary insiders, they must also report all of these trades executed on Forms 3, 4, and 5 alongside other legal insiders.

Using this insider trading database, we demonstrate that banks can and do access important, private, material information about their clients and appear to trade on this information. First, the inside information that banks acquire and trade on is highly valuable, allowing the banks to earn more on 25% on average on their proprietary trades. Second, we find that banks make money mainly on adverse information about their clients. Third, we find that relaxation and elimination of the Glass-Steagall restrictions allowed the banks to trade more frequently and earn greater amount of abnormal profits. Since 2002, banks tend to trade and earn more than 40% abnormal profits from adverse information about their client firms.

Consequently, we demonstrate that Volcker Rule would provide a substantial constraint on bank behavior. We show that an added benefit of enforcement of the Volcker Rule would be to eliminate the incentives to trade on adverse, material, non-public information about their clients by eliminating proprietary trading by banks. Thus, instead of eliminating it, we argue that enforcing the Volcker Rule would also help contain some the current conflicts of interest in the banking system resulting from the elimination of Glass-Steagall restrictions.

The complete article is available for download here.

Endnotes

1 See Heather Long, What the heck is the controversial Glass-Steagall Act?, CNN Money (Oct. 14, 2015, 1:57 PM), http://money.cnn.com/2015/10/14/investing/democratic-debate-what-is-glass-steagall-act/index.html; Julia Maues, Banking Act of 1933 (Glass-Steagall), Federal Reserve Bank of St. Louis (Nov. 22, 2013), https://www.federalreservehistory.org/essays/glass_steagall_act.(go back)

2See, e.g., Imogen Rose-Smith, The End of Proprietary Trading May Hit Banks’ Profits but Help Their Stock Prices, Institutional Investor (Dec. 30, 2010), http://www.institutionalinvestor.com/Article/2741999/Markets-Regulation/The-End-of-Proprietary-Trading-May-Hit-Banks-Profits-But-Help-Their-Stock-Prices.html#.WVPm-YTytaQ.(go back)

3Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 619, 124 Stat 1376 (2010).(go back)

4See 21^st Century Glass-Steagall Act of 2017, H.R. 2585, 115th Congress (2017), https://www.congress.gov/bill/115th-congress/house-bill/2585/text?q=%7B%22search%22%3A%5B%22congressId%3A115+AND+billStatus%3A%5C%22Introduced%5C%22%22%5D%7D&r=8. (go back)